Where interest rates are headed

Photo of Michael Saba, Evans & Partners By Michael Saba, Evans & Partners

min read

Floating rate notes in favour this year

These days it seems we go through a lifetime of markets in just one year. Such was 2016, where the year opened with a steep rise in volatility, a subsequent bond rally with central banks forcing interest rates down, intense political events with unexpected outcomes, especially the markets’ responses, and at the end of the year dramatically rising interest rates.

After this experience, it is doubtful anyone could predict 2017 accurately. However, we can make some assertions.

Combining newly elected President Trump’s pro-growth stance with global central banks inflationary policies, 2016 may be marked as the bottom of the 35-year bull market in bonds.

If there is one factor that moves interest rates up it is rising inflation. There were some inflationary signs before the US election, now it’s a major theme.

Globally, long-term bonds are rising in all major economies. The epicentre has been the United States, where 10-year treasuries jumped from 1.85 per cent to 2.38 per cent in the four weeks after the election. Many of the negative interest rates observed in Europe in 2016 have moved to positive.

Other markets are well correlated to the US. Australian 10-year government bonds rose from 2.35 per cent to 2.80 per cent in the four weeks despite a weak economy.

If rates continue to jump, holding fixed-rate bonds will hurt. Capital prices of fixed-rate bonds fall when interest rates rise. This effect is more pronounced the longer the time to maturity. Fortunately, Australian interest rate markets provide access to securities with the alternative payment style of floating-rate distributions.

(Editor's note: ASX glossary explains key interest rate securities terms.)

Floating-rate note (FRN) type securities do not contain the exposure to interest rates inherently contained in fixed-rate bonds. Their distribution levels are set relative to bank bill rates. While bank bill rates have not moved in recent weeks (the rise in interest rates has been in longer-term rates), even if they do move, the trading price of FRN securities does not have the responsiveness of fixed-rate securities. This is because FRN coupons are reset each 90 or 180 days. FRN-type securities are the predominant style among ASX-listed interest rate securities.

2017 interest rate outlook

Looking ahead, there are two immediate factors that will impact the ASX interest rate market. First, buyers seeking interest rate returns but wanting to avoid fixed-rate bond risks will look to FRNs more so than otherwise. Demand will be strong for ASX floating-rate securities such as sub notes and bank hybrids.

Second, of the $47-billion ASX bond and hybrid market, $2.6 billion was to be repaid in December 2016. Given these funds were already invested in the sector, it is reasonable to expect that some would be reinvested. Indeed, these two factors have already led to tighter ASX FRN security spreads. This should continue in early 2017.

The use of hybrids as part of bank regulatory capital appears quite stable for now. As issues come up to their cash repayment date, banks are expected to offer holders an alternative new hybrid. This has been the case for several years. For example, the Commonwealth Bank, ANZ Banking Group and Westpac all conducted replacement issues in 2016. IAG has already offered the May 2017 maturity IAGPC holders an alternative.

Bank issues for potential replacement in 2017 are ANZPC (September 2017, $1.34bn), SUNPC (December 2017, $560m), BENPD (December 2017, $269m) and WBCPC (March 2018, $1.38bn). The banks tend to offer reinvestment well ahead of the first repayment date. This is to remove the risk that market conditions may not be conducive to issue close to the existing security’s maturity date.

In addition, many of the non-bank subordinated notes are due for repayment in 2017. For example, Colonial Holding Company (March 2017, $1bn), Tabcorp (March 2017, $250m) and Caltex (Sept 2017, $550m).

Unfortunately, in this category in 2016, both Woolworths and Origin Energy chose to repay rather than replace. Major banks also have sub notes due for repayment about mid-2017. Again, these will need to be replaced as regulatory capital, either via issuance on ASX or in the wholesale markets.

Much of the redemption profile above paints a picture of a contracting sector. It was a similar outlook in late 2015, but this did not prove to be the case in 2016 when $6.27 billion of new bank hybrids were issued and $405 million of non-bank bonds, against $4 billion of bank hybrids redeemed and $750 million of corporate bonds. The sector expanded by about $2 billion. Where there is demand, supply eventually responds.

Traditionally from mid-February, issuance on ASX commences and we see no reason why 2017 should be different. Often, banks lead the new issuance, but with the advent of the new simple corporate bond legislation, new senior bonds from small to medium companies can also be expected.

Credit spreads were well supported in 2016, especially in the last quarter. Until the new supply commences, demand should keep spreads tight. This factor also helps stimulate issuance, as companies see the cost as low. In any case, the ASX bond and hybrid sector is as keenly sought as ever for yield.

About the author

Michael Saba has covered Australian hybrid securities for more than 15 years at several 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.

From ASX

Exchange-traded Australian Government Bonds has useful information on this type of bond, and links to other ASX material.

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