The cost for a bank to fund itself in Australia has increased, and is not directly related to the RBA Cash Rate. The impact of this affects investors in floating-rate notes and floating-rate XTBs; it may also affect mortgage costs and bank deposits.
BBSW and the impact on bank funding
A large part of an Australian bank’s funding references 3-month Bank Bills. A 3-month Bank Bill issued by a bank (a borrower) is bought by another bank or wholesale investor (a lender). The mid-rate between the lending and borrowing rate is used to calculate 3-month BBSW. 3-month BBSW is used as a reference for many financial products and sets the coupons on Floating Rate Notes and Floating Rate XTBs. Hybrids, which show many features of equity like instruments, also have coupons setting off BBSW.
Recent BBSW movements
BBSW has increased from a low of 0.26% above the RBA rate in Feb 2017 to approximately 0.54% above the RBA rate1. Therefore, BBSW has moved from 1.76% to 2.04%. So fiscal conditions have tightened even with out the Central Bank movement.
1 The RBA Cash Rate is currently 1.5%. Source RBA
Chart 1: RBA Cash Rate vs 3-month BBSW
The consequence is:
Investors in bank debt (buyers of FRNs) are receiving higher coupons and therefore benefiting from the increase in costs to the banks.
Banks face popularity vs profitability dilemma
Over the weekend, the press noted this increase in costs for banks gives them three choices to make if they want to maintain the same level of profitability.
- Increase mortgage rates. Business loans usually reference BBSW, so these customers already have the increase in funding costs passed directly to them.
- Decrease deposit rates or
- Some combination of both.
Read more here on this story in the press
However, market forces being what they are, a bank may consider raising deposit rates to attract more funding and requiring less from the wholesale markets. This would still therefore default to higher mortgage rates for maintaining current profits.
In the meantime, holders of floating-rate notes expect to enjoy higher coupons after the next coupon payment date, as the market tries to establish if this is simply a short-term change or a long-term structural shift.
Where investors should focus now
In light of this, floating-rate bonds are currently getting a lot of attention. There are 10 floating-rate bonds available via XTBs. Holding individual securities with XTBs offers greater predictability when compared to investing in a floating-rate ETF, but both options give investors the simplicity and flexibility of investing via ASX.
XTB Cash Plus Portfolio – A ready-made solution?
If you like the predictability and choice of selecting individual securities, but still want some direction, the XTB Monthly Income Portfolio may be worth closer inspection. The portfolio contains just 3 floating-rate XTBs but provides monthly income as the bonds included pay coupons in each month of the year.
- XTB Monthly Income Portfolio
- Cash Flow Tool
- Insights Article: Is it time to float away with bonds?
- Insights Article: BBSW – 6 key facts behind what it is and how it’s calculated