Finding attractive yield in 2017
Good yield opportunities remain if you know where to look across ASX.
This article reviews key markets for yield-focused investors in 2016 and outlines favoured strategies for 2017.
The official cash rate started 2016 at 2 per cent and ended at 1.5 per cent with two 0.25 per cent interest rate cuts. The 90-day bank bill rate is currently 1.75 per cent and the 180-day rate is 2.0 per cent, suggesting the market does not expect a further cut in interest rates.
Three-year and 10-year bond rates followed the cash rate down until August.
Both then started rising, further fuelled by the US election result in November increasing the probability of a rise in US interest rates. Bond rates and swap rates are benchmarks against which all fixed-interest securities are priced.
The chart below demonstrates the behaviour of ASX-listed hybrids through the Commonwealth Bank PERLS VII (ASX Code: CBAPD), which was issued on 2 October 2014.
The prices of hybrids are essentially affected by accrued interest (per other interest-bearing securities) and credit spreads. Movements in interest rates have little effect as the rate on these securities is typically reset every 90 days.
The banks have issued large quantities of hybrids and the peak margin for the new issue of a hybrid was 520 basis points (including franking credits) over the bank bill rate by the CBA (PERLS VIII) in March 2016. The chart shows this was around the low for the CBAPD price and that capital gains have been made since.
The margin increase reflected two factors:
1. The market had to establish a margin for a new, and complex, security.
2. Institutions initially shunned these securities, which left the heavy lifting to retail investors. The banks continued with large issuance.
Property: Australian Real Estate Investment Trusts (A-REITs) – yields are 5.0 to 6.0 per cent
The A-REIT market significantly outperformed the ASX 300 until a retracement began in August, which has been attributed to price: net tangible assets of AREITs being too high and to the lower net present value for AREITs, ascribed due to the higher long-term bond rate.
Income stocks (typically banks): 7 to 9 per cent including franking credits
The Bank Accumulation Index underperformed the ASX 300 Accumulation Index over 2016.
Some analysts are expecting this trend to continue if long-term interest rates continue to rise. We prefer the subdued growth in earnings per share/possible dividend reductions as the explanation.
Markets in 2017
A rate cut is still viewed as unlikely, with the odds of a February cut at around 1 in 12, rising to about 1 in 7 by May. The probability of a rate rise is almost equally unlikely, with a rise in November 2017 regarded as a 1 in 12 chance.
Hence the likelihood is that the cash rate will remain steady over the next 12 months.
The 10-year bond yield has risen by 1 per cent since its low in October. This has primarily been because of increases in US bonds. Analysts expect short-term US interest rates will soon be raised because of the strength of the US economy.
Although Australian rates often track those in the US, the respective economies are performing significantly differently. Australian bond fund managers are not unanimous that domestic long-term rates will keep rising.
Strategies for 2017
- The highest confidence is that the cash rate should remain at current levels, so a 12-month term rate at higher levels is attractive.
- The three-year government bond rate has risen by 0.60 per cent per annum, but the three-year term deposit rate has not yet adjusted. Term deposit investors could consider delaying a three-year fixed deposit.
- Commercial rates tend to reflect change more quickly. Hence fund managers are investing in credit securities with this higher rate. With a risk that 10-year rates will continue to rise, funds with an interest duration of five years or less could be preferred.
About the author
Matt Wilson is CEO of YieldReport, the only independent report in Australia analysing interest rate markets. He started his career in the fixed-interest markets before working in derivatives for many years. He was instrumental in the launch of the equity warrant market in Australia, New Zealand and South Africa, before launching the first CFD business in Australia at IG Markets. YieldReport’s weekly newsletter carries regular coverage of the fixed-income, yield-related sectors and can be obtained by registering.
Matt Wilson is CEO of YieldReport, the only independent report in Australia analysing interest rate markets. He started his career in the fixed-interest markets before working in derivatives for many years. He was instrumental in the launch of the equity warrant market in Australia, New Zealand and South Africa, before launching the first CFD business in Australia at IG Markets.
YieldReport’s weekly newsletter carries regular coverage of the fixed-income, yield-related sectors and can be obtained by registering.
The ASX RBA Rate Indicator shows market expectations of a change in the Official Cash Rate (OCR) set by the Reserve Bank of Australia. The indicator calculates a percentage probability of an RBA interest rate change based on the market determined prices in the ASX 30 Day Interbank Cash Rate Futures.