In light of low government bond yields (the 10-year German bond yield has fallen below 2.4%) and the contraction of the interest rate differential between (investment grade) corporate and government bonds, investors need to get off the beaten track to get a higher regular income. Here are some suggestions:

• Bonds denominated in other currencies: Quality bonds denominated in AUD, NZD and BRL are offering yields above 5% for example. There is an obvious exchange risk to be borne in mind especially in light of these currencies’ recent appreciation. We think that in the long term, their upward trend is set to continue given the sound fundamentals of these countries. Interim corrections should not be ruled out however, especially given that some of these currencies are perceived as being cyclical as they are linked to commodities. Given the interest rate differential with euro-denominated bonds, investors do have some margin of safety, however.
  
  Example:
  A Siemens 4-year bond denominated in euros currently offers a yield to maturity of around 2%. A Nestlé bond in Australian dollars with a similar maturity offers 5.2%. At current exchange rates, one AUD is worth 0.72 EUR. The interest rate differential is such that the Australian dollar can fall to 0.645 EUR (i.e. by around 10%) BEFORE the return on the Nestlé bond (when held to maturity) falls below the Siemens bond.

Total return over 4 years (in %)

AUD/EUR exchange rate over 5 years

• Microfinance: Some Banque de Luxembourg funds have been investing in this area for two years with rather convincing results. The Bank has decided to launch a microfinance fund (BL Microfinance Fund) to offer its clients access to this asset class. It will be a closed-end (capitalisation) fund with a 3-year maturity (31/12/2013). The subscription period will start in October and the minimum investment is EUR 125,000. In light of current market conditions, the fund is targeting a net annual return of around 5%;
• Euro-denominated bonds from riskier issuers - including government bonds (Greece, Portugal, etc), and corporate bonds. We do not hold any Southern European government bonds in our bond and balanced funds, although we do have government bonds from a number of emerging markets. As far as corporate bonds are concerned, we tend to prefer stocks from quality companies, rather than bonds issued by companies with more or less high levels of debt on their balance sheets. The only high-yield bonds in the portfolio of BL-Global Flexible are issued by the Mexican company Cemex, the third-largest cement manufacturer in the world after Lafarge and Holcim. The yield to maturity on these bonds, one of which matures in 2014, the other in 2017, is around 10%. Prior to a major acquisition made just before the crisis (Rinker Materials in Australia in 2007), Cemex had the reputation of being one of the best managed companies in Latin America. Following the takeover, which was financed through debt, the company was forced to renegotiate the conditions on its bank loans. Since then, Cemex seems to be back on track again. A significant share of its revenue is generated in the United States. Cemex’s current credit rating is ‘B’, a clear reflection that its loans are certainly not without risk and are not suitable for all investors;
• Less classic euro-denominated bonds: Over the last years, some companies have issued perpetual (often subordinated) or very long-dated (100 years) bonds. We hold some of these types of bonds issued by German companies Bayer, Linde and Henkel. These bonds usually pay a fixed coupon for a couple of years after which the coupon becomes a variable coupon based on money market rates, plus a margin of 200-300 basis points (2%-3%). The company usually has the possibility to pay back the bond before maturity at set dates. For example, the Bayer bond was issued in 2005 with a maturity of 2105 and pays an annual coupon of 5% until 2015. From 2015, Bayer has the possibility to pay back 100% of the loan. If it does not pay back the loan, the annual coupon will switch to the 3-year interbank rate plus 280 basis points (2.8%). As is the case with classic bonds, these kinds of bonds can be sold at any time in the market. It is important to note, however, that in periods of strong turbulence (such as in 2008), prices offered for these bonds tend to be heavily penalised (due to their long maturity date) and may no longer accurately reflect the issuing company’s fundamentals. An investor who may have to sell during such a period could suffer a significant loss;
• Dividend stocks: many companies are paying a very attractive dividend in light of the low level of interest rates. Some companies’ stocks are even offering a higher return than their bonds. An example is the French company Vivendi. At its current price, Viviendi’s 2014 bond is offering a 2.8% yield to maturity, while the Vivendi stock is offering a net dividend yield of 5.3%. Obviously, stocks are more volatile than bonds – and a company has to pay interest on its debt before paying out dividends. However, for investors unperturbed by such volatility and who are simply looking at the result of their investment in 2014, the Vivendi stock is an attractive alternative to the bond. As in the AUD bond example above, the higher return offered by the stock provides a margin of safety in the event that the Vivendi share price falls. The share price could, therefore, fall 10% from its current level BEFORE the return on the Vivendi stock falls below the return on the Vivendi 2014 bond. Note that the Vivendi share price has already fallen by around 40% in the past three years.

Vivendi’s share price performance over 5 years

In conclusion, the suggestions above come with a (much) higher volatility than traditional fixed income investments. This is the price to pay for a higher return. However, this should not constitute a major issue for investors with a long-term investment horizon.