Riskier investing has been well and truly back ‘on’ over the past few months, but what has fundamentally changed? I would argue not much, so perhaps it is time to take some risk off the table, move up the credit curve, and come back when things look a little more favourable.

The last two months have seen a definite trading move to riskier investments. Investors have moved down the capital structure and bought heavily into equities and higher-risk credit, including hybrids, in a search for yield. This has helped drive the ASX200 up 13.4% from its lows in June to the end of October. Similarly, some of the higher risk listed hybrids like Seven Group Holdings (ASX:SVWPA) and Multiplex Sites (ASX:MXUPA) have appreciated by 12.3% and 9.45% over the same period.

But have any of the fundamental risk factors present in the market over this period disappeared?

Last night, the Greek parliament voted in favour of the €18 billion (A$22 billion) in austerity measures, sparking riots and demonstrations. A vote on the Greek budget follows on Sunday. At risk is a €31.5 billion (A$38.7 billion) tranche of the International Monetary Fund’s (IMF) bailout package necessary to ensure Greece doesn’t default, and thus remains part of the European Union.

Meanwhile, in the US, despite the distractions of kissing babies and the debate about whether Jeep is indeed planning on manufacturing in China, the fiscal cliff draws nearer. Should the fiscal cliff (a term used by Federal Reserve Chairman Ben Bernanke to describe the effects of tax increases and spending cuts agreed by congress and likely to result in a double-dip recession) or the debt-ceiling be reached….well, let’s just say risk will no longer be ‘on’.

When the market turns its focus back to these issues, and the myriad of other issues still unresolved in the global economy, they will look to move out of risk, and back up the capital structure.

So how do you, the SMFS investor, look to move out of risk?

Understanding capital structure

One of the fundamental keys in fixed-income investing is the concept of the capital structure. Most companies are made up of a mix of capital (debt and equity), larger companies tend to have more complex capital structures with different levels of debt, and sometimes different levels of equity. The capital structure (as shown below in Figure 1) defines the layers of a company’s capital structure, with the highest risk in the structure – equity – at the bottom and the least risky – senior secured debt – at the top.

On a basic level, an investor expects to earn better returns from investments further down the structure to compensate for the extra risk. But an active investor (as opposed to a passive investor) can look to increase overall returns by avoiding drops in capital, by moving up the structure to lower risk investments at opportune moments, returning down the structure when the payoff returns.

In debt markets, when investors are seeking risk, we see spreads reduce. That is, the amount of interest investors are willing to accept on risk decreases. The decrease is inevitably exasperated further down the credit structure as investors seek more risk and more return. So you would expect to see yield for the riskiest fixed-income securities, hybrids, decrease more than that of higher quality securities further up the capital structure. This is called spread compression.

This is exactly what we have seen happening with spreads on lower quality assets – for example, Heritage’s (ASX:HBSHA) spread over the 90-day bank bill rate has reduced by 123 basis points since October 10, and the Westpac’s hybrid (ASX:WCTPA) has come in 84 basis points. These both represent significant movements in the fixed-income markets.

Over the same period, senior bank bonds from Westpac have moved only 16.8 basis points. When this spread compression occurs, it becomes more advantageous for investors to move up the credit curve to less risky bonds, and wait for the market to re-price risk before moving back down the structure.

Investors may look at the return of the senior bonds and prefer the attractive yields on offer from hybrids, but what if the 10% gains of the last few months reverse?

Markets remain wary, any hint of trouble from Europe, China or the US could see the risk-on trade reverse quickly, and the best way to protect your capital is to be higher up the capital structure.

So bank your profits, remove your risk, and chase yield another day.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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