This article appeared in the February 2013 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.
In a major development for investors, Exchange-Traded Australian Government Bonds (AGBs) will trade on ASX this year. As Evans & Partners' Mike Saba explains, government bonds play key role in well-structured portfolios.
By Mike Saba, Evans & Partners
It's finally here. After years of waiting, and an obvious need, government bonds are to be available for all investors on ASX in late March. Exchange-Traded Australian Government Bonds (AGBs) will trade alongside all ASX-quoted securities. They will enjoy the benefits of listing, such as trading in small or large parcels, ease of settlement, and the efficiency and low cost of registration in CHESS.
This means that a current user of ASX will be able to simply buy and sell AGBs just as they can trade BHP Billiton or a Commonwealth Bank hybrid security. Their current broker account, associated settlement mechanisms and income direction instructions (for example, where dividends/coupons are paid) will apply.
(Editor's note: Learn about the features, benefits and risks of fixed and floating rate investments by taking the free, online ASX interest rate securities course.)
The benefits of AGBs trading on ASX include:
- Aggregation of buyers and sellers to create liquidity
- Transparency of pricing
- Large and small participants have equal access
- Ease of trading through ASX broker network, potential integration into broker portfolio management systems.
There are many reasons to invest in AGBs, which will be discussed later, in particular:
- The ability to hold the highest quality investment
- To gain exposure to falling interest rates
- As a backbone of a diversified portfolio or specific bond portfolio
- As an insurance mechanism to counterbalance more potentially volatile parts of a portfolio.
What will be listed?
Most existing Treasury Bonds (TBs) and Commonwealth Treasury Indexed bonds (TIBs) will be listed. In particular, 17 TBs and 5 TIBs, all differing in coupon (for example, TBs vary from 3.25 per cent to 6.25 per cent) and maturity date (December 2013 to April 2029) will be available on ASX. These TBs and TIBs all trade in the wholesale marketplace, hence that market can be used to keep pricing in line for the listed securities.
How Treasury Bonds will work
TBs are a standard bond, a simple investment product. Investors purchase either at issue date at face value (usually $100) or subsequently in the market, which will be the case for Exchange-Traded TBs. Interest payments, termed coupons, are paid at a set rate and set dates (in the case of TBs each six months).
At a defined date the bond is repaid at face value. Investors must be aware that the coupon rate is only the overall annual return rate when a bond is issued. Subsequently, as market rates move and time to the next coupon approaches, the total yield of the bond needs to be recalculated. This is termed yield to maturity (YTM) and assumes the investor holds to the redemption date (YTM is further described below).
Treasury Indexed Bonds
TIBs are a similar concept to a standard bond, but the face value is increased by the rise in the CPI. Interest is paid quarterly based on the adjusted face value. In this way investors can protect against inflation - the capital invested increases constantly by the inflation rate.
For TIBs the maturity date is usually long term. Four TIBs have maturities from 2020 to 2030. If the inflation rate falls, the face value will be indexed down but cannot fall under $100.
The current level of economic stimulation via the RBA lowering cash rates is thought by many commentators to lead to an increase in inflation in future years. There will be a time for holding TIBs as an excellent method to protect against inflation.
Why invest in government bonds?
Investors should have a diversified multi-asset portfolio, which should include in general a weighting to bonds. Bonds provide steady low-volatility returns. This is extremely important as retirement approaches or begins. Weightings to bonds should increase as commencement of drawdown approaches. Holding a TIB gives inflation protection, important for those needing to maintain their purchasing power over time.
As an alternative to a multi-asset portfolio, a very risk-averse investor may hold AGBs as a standalone investment or as part of a bond-only portfolio. There are various sub-asset classes of bonds, with issuance from the Commonwealth Government, state governments, banks and corporates.
In each of these groups, there are a variety of bonds. From the Commonwealth there are TBs and TIBs, as mentioned, from banks and corporates there are bonds with different ranking in the issuing companies' capital structure, which then offer different potential yields.
Holding government bonds gives either a balanced or bond-specific portfolio backbone for risk-averse returns. Other asset types can be added to seek higher returns. In the case of a multi-asset balanced portfolio, this may be equities or property. In the case of a standalone bond portfolio, this may be higher-yielding corporate bonds. Any portfolio should have risk exposures spread (by holding different types of bonds).
A holding in government bonds helps counterbalance riskier exposures. This is especially important in times of market volatility. We saw many times during and since the GFC how government bonds respond when risk or fear rises or a major negative event unfolds. Money moves into government bonds because they are the safest asset class and pay a return.
As a result, in times of stress, bond prices rise and interest rates fall (see more discussion on how this works below). This gives rise to the protective nature of government bonds. Rising bond prices under this scenario will offset a fall in other asset classes that are negatively impacted by the rise in market volatility.
In some sense government bonds, if held in high enough weighting, can be a form of portfolio insurance. Hence they allow risk in other areas to be taken and yet they still provide a yield. It is hard to act after a risk event; prudent risk-averse portfolios hold government bond weightings in advance.
The yield on a government bond may look low in isolation, but a key factor is the consistency of return and the offsetting of other risks. Looking at overall returns from holding government bonds since 2000 paints a picture of steady returns. Some of these returns have been driven by the steady decline in interest rates over this period.
Nevertheless, at any point in time relative to the cash rate, government bonds offer competitive returns, especially when their protective nature is taken into account.
On any given day the yield to maturity (YTM) for an AGB can be calculated from the trading price. These yields will vary from the coupon rate, as general market rates would have changed since the date of issue. Using a YTM helps equilibrate all bonds relevant to each other and the level of general interest rates in the economy (often represented by "swap rates").
The table below gives an example of AGB pricing. The first bond, with a June 2014 maturity and 6.25 per cent coupon, has a YTM of 2.70 per cent. The second has an October 2014 maturity and a coupon of 4.50 per cent, and a YTM of 2.73 per cent.
|AGB June 2014 maturity||6.25%||$105.51||2.70%|
|AGB Oct 2014 maturity||4.50%||$104.17||2.73%|
Source: Evans & Partners
First, note the YTMs on these bonds vary from the coupon rate; they are relevant to market rates. Second, the YTM for the October bond is higher than the June bond. This is expected, as in the case for all investments the longer the time to repayment, the higher the required risk premium and hence YTM. Chart 1 shows how the YTM for AGBs with different maturity dates changes with time to maturity.
Chart 1. Yields on AGBs with different maturities
Source: Evans & Partners
Interest rates and AGBs
All Australian Government bonds and hence exchange-traded AGBs pay fixed coupons for the life of the bond, rather than coupons set relevant to a moving benchmark such as bank bills. Buying a long-term, fixed-rate bond locks the yield in for the period, but it also creates much interest rate sensitivity.
As interest rates rise, the yield on the bond must adjust to be competitive. Given the coupon is fixed; the price must fall to adjust the overall YTM.
An investor may be happy with the purchased yield for the long period of time, but if for some reason they need to sell before maturity, they may suffer a capital loss. Investors not wanting this risk should hold bonds with short times to maturity.
This interest rate sensitivity can also work in reverse. If interest rates fall, the bond will rise in value. As mentioned above, this is one reason investors flock to government bonds in times of market stress, apart from investing money with a government capital guarantee.
If the view is that interest rates will fall, investors can capitalise by holding fixed-rate bonds. The longer the time to maturity, the greater the interest rate sensitivity. If a bond price has moved because of interest rate sensitivity or another factor, the price may vary greatly from the $100 face value.
So long as the issuer is able to repay, as maturity approaches, the bond price moves back towards face value. Given there are a wide range of maturities of AGBs, the risk of interest rates rises can be reduced by holding shorter-dated AGBs.
A safe haven in times of volatility
If worried about the markets, enacting this view via AGBs is an ideal safe investment idea. The level of interest rate sensitivity can be determined in advance. We will cover this topic another time, but as a rule of thumb, a bond with five years until redemption and a 4 per cent coupon will rise (fall) by 4.5 per cent in value if five-year interest rates fall (rise) by 1 per cent.
In price terms, a fall in rates of 1 per cent would increase a five-year bond's capital value from, say, and $100.00 to $104.50. Any interest earned for the period would be additional to this price movement.
This illustrates that holding a bond is not as boring as some would suggest. In comparison to a fixed-rate term deposit, holding a bond is superior in that the bond can be traded every day to capture advantageous price changes, whereas a term deposit cannot.
Bond markets are active every day, especially vibrant when interest rates are moving. Now all investors can access AGBs via ASX for a range of reasons. Investors should consult a broker who can provide interest rate market information and each bond's interest rate sensitivity.
A few technical bits
The holder of an exchange-traded AGB will have beneficial ownership via CHESS, rather than holding a physical bond. This is achieved via CHESS Depository Interest (CDI) which gives the holder all the economic benefits (including payments) that come with legal ownership of the underlying individual bond. Investors must have a broker-sponsored CHESS account. All transactions must be electronically settled via brokers.
Market pricing for AGBs will follow the same mechanisms as for other listed interest rate securities. The price is quoted in cents. For example, a bond with value of $101.50 would be quoted as 10150. Pricing increments can even be lower than a cent, down to tenths of a cent; hence a price may be quoted as 10150.1.
Each bond will have a six-character code starting with GSB for TBs or GSI for TIBs, and finishing with two numbers that refer to the maturity year; for example, a 2018 maturing bond would end with 18. Middle characters will refer to the month, A for January and so on. A code GSBS15 would be an TB maturing in October 2015.
As for other listed interest rate securities, the traded price of TBs and TIBs will include accrued interest. Additionally, like other listed securities, Exchange-Traded AGBs will have a "record date" for payment registration and an "ex-interest date", approximately eight days before the actual coupon payment date. As with a share, you need to own the AGB before the ex-interest date to be eligible for the upcoming payment.
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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