This article appeared in the December 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
Mike Saba explains the bond bubble and how you can do better than the cash rate.
By Mike Saba, Evans & Partners
As 2012 draws to a close, it is timely to discuss what can be earned on yield investments in the context of current interest rates, which in general are at lows as central banks worldwide act to stimulate economies.
Australia is no different, except its interest-rate cuts started from a higher level. The Reserve Bank still appears to be in a rates-lowering phase, but further cuts in the short term depend on economic data, with the RBA also closely watching the performance of international economies.
(Editor's note: ASX Interest Rate Securities provides useful information for those wanting to learn more about fixed - and floating-rate products.)
The local market forecasts rates to drop at least a further 0.5 per cent by the middle of next year, from the current cash rate of 3 per cent.
As shown in the chart below, interest rates in Australia are at 30-year lows, with steady falls over the past 12 months. As interest rates fall, the value of a fixed-rate bond rises. This is shown by the S&P/ASX corporate bond index, which rose 12.27 per cent in the year to October 31. Of this return, coupon comprises 6.88 per cent and capital return 5.40 per cent, due to rates falling 1.3 per cent over the period.
Recent "bond bubble" headlines refer to the low level of interest rates and that to maintain such returns, interest rates need to keep falling, which is partly true. However, with rates so low, further falls may not be large, although as we have seen in the US, they can keep falling to new historic lows.
Australian Government bond rate line chart - Nov 1976 to Nov 2011
Source: RBA, Iress
Low yields a problem
Nevertheless, it is hard to get excited about a Government bond yielding 3 per cent unless you are extremely risk averse. As the business cycle turns, rates will eventually rise and such low yields will be unattractive, with holders potentially suffering capital loss if they sell before maturity. This is why the headlines cite a "bubble".
Putting it another way, if rates rise there is opportunity loss (in that higher rates on investments could have been obtained). This is an understandable concern, but to dismiss interest-rate markets is to miss a key element. Investors are not forced to hold fixed-rate bonds, which lock in the yield. Corporate bonds also offer coupons in floating-rate style. The distributions are set according to a premium above the bank bill rate. Hence the level of coupons paid rises and falls with the level of short-term interest rates. This has been a negative when rates have been falling, but will be a positive when they rise.
Investors need to balance the low level of rates against their proportion of fixed- and floating-rate coupons to protect against rising rates and to avoid being locked into low coupons.
Fortunately, the ASX Interest Rate Securities market contains a large number of floating-rate bonds and hybrids. Looking at all listed floating-rate securities, the average coupon margin above bank bills is 3.50 per cent. This means the security would have a running yield 3.50 per cent above the current 90-day bill rate of 3.25 per cent, hence around 6.75 per cent.
This is a healthy yield and more than comparable to fixed-rate bond yields. So unless an investor feels rates are to fall dramatically further, floating-rate securities will provide healthy yield and avoid the "bubble". When interest rates do rebound, the first part of the rise will be quick as many investors attempt to catch the move. Indeed, the chart shows rates have already edged up in anticipation, despite a good chance of more cuts to the cash rate. Remember that the RBA only moves the cash rate. Longer-term rates are subject to market forces.
Strong demand for ASX-listed bonds
A pleasing factor from the $12 billion of bonds and hybrids issued in 2012 was the issue of security styles further up the capital structure. Many senior and subordinated bonds were issued from non-financial companies as well as the banks, in addition to the usual array of hybrids. The result is that investors have more issuing companies and a wider range of security (ranking) levels to choose from. Hence in a portfolio of interest-rate securities, another achievable diversification vector is where the bond fits in the capital structure. Diversification categories in general are:
- issuing company payment style
- fixed or floating
- ranking in the capital structure
- tenor of issue
- franking and
- timing of payments.
Changes in some of these factors (in particular payment style and tenor) will influence the sensitivity of the portfolio to changes in the level of market interest rates. A portfolio should have a spread of each factor above.
More choice coming
The choice of bonds should in future broaden even further, with more issuance expected in the sector, especially with the political push to enhance the corporate bond markets in the wholesale over-the-counter and listed market forms (via ASX).
With this wider range, it is becoming even more important to also research the issuing company from a credit perspective and on how the bond/hybrid holders are treated. Margins on bonds, including floating-rate style, are commensurate with the risk of the underlying company. A challenge is to be abreast of each issuing company's risk profile so that quick trading decisions can be made.
The margin a bond trades at over reference rates, the "risk premium", can vary from week to week, not only as news about each company flows, but also from the general level of risk the market is placing on corporate debt. It is important to have accurate and up-to-date yield calculations at hand.
Many factors influence risk premiums. The "risk off" market, when negative offshore events unfold (European banking crises), or there is poor local economic news (rising unemployment), tends to increase risk premiums. Good economic or company news tends to lower risk premiums. An eventual rise in interest rates will likely be associated with an improving economy, which would be positive for corporate bonds. Investors must keep abreast of general market factors as well as how the individual company is travelling. A good financial adviser should be able to help in both regards.
A financial adviser should also be able to supply yield information for all securities in the market so that investors can gauge potential returns from interest-rate securities. He or she should also be able to put all held or prospective yield securities together in a portfolio model to assess not only the overall returns, but potential risk factors that will arise from the categories listed above. Credit research on the issuing company is also required.
Investors can now choose from an increasing range of interest-rate securities. Floating-rate corporate bonds and hybrids should be considered in a diversified yield portfolio, especially as current floating rate yields are healthy, and that it can be difficult to time interest-rate changes. Investors concerned about low rates should avoid being locked into fixed-rate bonds, and should diversify in style of payments as well as issuing company and security ranking.
About the author
Michael Saba has covered Australian hybrid securities for more than 15 years at a number of Australian broking houses. He specialises in analysis and sales of derivatives to institutional clients, and polled No. 2 in his sector in the 2009 BRW East Coles Survey. He is Head of Derivatives at Evans & Partners in Melbourne.
ASX Interest Rate Securities provides useful information for those who want to learn more about fixed-income products, such as:
- Corporate bonds
- Floating notes
- Convertible notes
- Hybrid debt securities.
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