When will interest rates rise?

Photo of Matt Wilson, YieldReport By Matt Wilson, YieldReport

min read

What it means for bonds, and fixed and floating rate strategies.

The aftermath of the financial crisis in 2008/2009 saw the lowest global interest rates on record. This was a disaster for those seeking a secure income stream from their investments but the “emergency” interest rate levels employed by central banks were largely designed to be temporary, so economies could get back on their feet swiftly.

Well into the third quarter of 2017, much of the world still has interest rates at record or near-record lows. The strategy looks anything but temporary, but this may be changing.

US rates are moving higher and this usually signals higher rates around the world. The US is the world's dominant financial market and its benchmark 10- year bond rate is the rate by which all other risks are effectively measured.

When US bond rates rise, investors generally demand a greater return for investing in other bond markets, such as Australia. The extra yield in markets such as Australia is the offset for additional perceived risk.

Wilson AUS vs US 10 year bond chart

In December 2015, the US Federal Reserve raised the federal funds rate (similar to the Australian cash rate) for the first time in a decade. It made a further three increases in 2017. Markets are anticipating further interest rate rises in coming months and US bond rates have reacted accordingly and started to rise.

Rate cycle adjusting

Is this the turning point for interest rates and, if so, what does it mean for Australian rates and how should investors position their portfolios to maximise income?

Interest rate investments largely come in two types: fixed rate or floating rate. A fixed-rate bond makes regular income payments (called coupons) with the face value (principal) repaid on maturity.

A floating-rate instrument also pays a regular income stream but the rate adjusts, usually every quarter, in line with prevailing market rates. The floating rate is usually referenced against a market benchmark such as the Bank Bill Swap Rate (BBSW), which is published daily.

In a falling interest rate environment, investors should logically invest in fixed-rate assets as the coupon payment will remain the same even if interest rates fall.

Conversely, when interest rates are rising, investors are best off in instruments where the interest rate is adjusted every few months to a new, higher rate.

So, investors typically have a threshold decision to make – fixed or floating interest rate.

There is a caveat. Even if you believe interest rates will rise, a fixed-rate strategy might work for you. For example, a term deposit is a fixed-rate instrument.

If you believe rates will rise, a sensible term-deposit strategy would be to invest in shorter-term deposits such as for three months or six months and reinvest at higher rates later on. Investing in a three-year or five-year fixed-rate term deposit or bond is not a good idea in these circumstances.

One great feature of fixed-rate bonds is the holder on the maturity date will receive the face value. A problem arises if you need to sell the bond before maturity and interest rates have risen. The market price for the bond may fall below $100 to compensate for the fact the bond is paying a fixed rate and the prevailing market interest rate has increased above that fixed rate.

This not only happens with bonds but also other investments such as infrastructure shares or real estate investment trusts. These investments typically fall in value to compensate for the fact interest rates have risen and their business incomes do not rise commensurately.

Let's look at some investment choices based on current yields.

Asset Income/Yield % Fixed/Floating
Cash account 1.5 Floating
Cash ETFs 2.05 Floating
Term Deposit 1 year 2.5 Fixed
Term Deposit 3 year 2.7 Fixed
term deposit 5 year 2.9 Fixed
3-year givernment bonds 1.98 Fixed
10 year government bonds 2.64 Fixed
ASX-listed notes 3.1 Floating
ASX-listed hybrids 5 Floating
Shares 4.2 Prices generally fall when interest rates rise
REITS 5 Prices generally fall when interest rates rise

1 YieldReport survey 25 August 2017. 2 Includes franking credits. 3 Some share prices are positively correlated to higher bond yields (i.e. miners) but share prices and unit trust prices generally fall as interest rates rise.

Floating-rate investments
Most floating-rate instruments, including almost all the preference shares, capital notes and notes listed on ASX, pay distributions linked to the floating Bank Bill Swap Rate. If BBSW were to rise, holders of securities would receive more interest and their incomes would increase at the next rate adjustment.

Wilson RBA Cash rate vs 3 month BBSW

Other floating-rate investments

Cash accounts are essentially a floating-rate investment and so are cash exchange-traded funds (ETFs) and enhanced cash ETFs. There are also bond ETFs such as the recently listed BetaShares Australian Bank Senior Floating Rate Bond ETF, which invest entirely or predominantly in floating-rate instruments.

Inflation-linked bonds as an alternative

Inflation has been largely absent from investors' thoughts but a sudden outbreak could see inflation-linked bonds (ILBs) come back into favour.

A normal bond, let’s say with a five-year maturity and a face value of $100, generates regular fixed income and pays $100 on maturity. This is fine, except if inflation is high. The purchasing power of the $100 in five years’ time will be eroded.

ILBs, however, adjust the face value of the bond each quarter along with the rate of inflation. This protects the long-term purchasing power of the investment.

An unusual rate cycle

Rising and falling interest rates are all part of the investment cycle but the current cycle is, frankly, unlike anything seen in history. Interest rates have been stuck at record lows and central banks are reluctant to raise them lest it crimps economic growth.

Wilson RBZ vs FED chart

US bond rates have been slowly rising as the Fed attempts to “normalise” interest rates.

In the past, higher US rates has led to higher interest rates around the world. Australia is behind the US in the economic cycle but has not been through the recession, nor the high unemployment, experienced there.

The Reserve Bank appears to be in no hurry to raise short-term cash rates even though longer-term bond rates may rise in sympathy with the US. This is the dilemma for interest rate investors.

In past economic cycles, rate rises and falls have been relatively predictable. The present cycle is anything but normal and makes forecasting rates fraught with danger.

Notwithstanding this, the perceived fragility of the global economy is such that the rate increase cycle is likely to be longer than any previous one.

Central banks have spent the past 10 years trying to generate growth and inflation. They will be loathe to raise rates quickly for fear of hindering whatever growth there is.

The only thing for certain is that deciphering central bank speak is an art form. A famous quote, often wrongly attributed to Alan Greenspan, former chairman of the US Federal Reserve, sums this up: “I know you think you understand what you thought I said, but I'm not sure you realise that what you heard is not what I meant.”

About the author

Matt Wilson is CEO of YieldReport, the only independent report in Australia analysing interest rate markets. YieldReport weekly newsletter can be obtained by registering.

From ASX

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