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Increased interest in Bonds and Hybrids

Over recent months the Reserve Bank of Australia (RBA) has increased the cash rate by 50 basis points from 4.75% to 5.25%. For many people, this will not only affect their mortgage repayments, but also their return on Bonds and Hybrid Securities listed on the ASX.  In this article we will look at the impact of these changes on the value of Interest Rate Securities.

As interest rates rise, the market value of fixed Interest Rate Securities (Bonds and Hybrids) falls. This is a result of buyers moving away from issues at old rates and taking up new issues at the higher interest rates.

Current holders of fixed interest securities also tend to move out of their holdings seeking these new higher rates of return. Consequently as the demand for old fixed interest securities decreases and their supply increases, their market price tends to fall.

Interest Rate Securities with a floating rate of return have the ability to buck this trend. By virtue of their yield calculation being made as a margin over a current market rate (generally the Bank Bill Swap Rate), their yield is free to move upwards in line with increased rates. These securities are listed on the ASX Interest Rate Market and are known as Floating Rate Notes.

Also listed on the ASX Interest Rate Market are Hybrid Securities. The market price of Hybrids will act in the same way as Bonds. However Hybrids do have additional features beyond a standard Bond. Hybrid securities are able to offer investors a dividend payment as opposed to a coupon payment. If the dividend is fully franked then holders of the Hybrid will be eligible to receive a tax benefit. Put simply, if a Company has already paid tax on their profits and then pass these profits on to you the investor, the dividend will not be taxed a second time. Your tax agent can discuss this concept in detail.

Conventional theory dictates that rising interest rates will tend to have a negative or bearish effect on the sharemarket. This is a consequence of the increased cost of borrowing reducing business' capacity for expansion.

Previous bearish markets have seen investors move part of their portfolio into the ASX Interest Rate Market as a strategy to preserve capital and gain a degree of income certainty with the coupons/franked dividend payments that Bonds and Hybrids offer.

There has been considerable speculation around the possibility of further interest rate rises. Investors may have considered delaying investment into a fixed interest vehicle in an attempt to gain advantage from a higher rate of interest. Be mindful of the yield-earning window that can be forgone by holding funds in cash whilst waiting for a possible rate rise. 

The tortoise and the hare fable might help to understand this concept; the longer you delay an investment decision the faster you may then have to run to catch up.

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