I have been a bond trader globally for the last 30 years and I have given advice to global pension funds and asset managers. When I set about the task of building a portfolio, I use a model to help decide if I should use fixed or floating rate XTBs.
The model I use has multiple inputs, but for the purposes of this article I will discuss just the core inputs, in case you would like to replicate my model.
I establish an overarching framework and define the key inputs such as:
- Over what period of time am I considering investing?
- What do I think will happen during the investment period?
- What will the ‘Total Return’ of XTBs be over the period – under a specific interest rate assumption?
Then I compare results for both fixed and floating-rate XTBs.
So let’s unpack these inputs in question and answer form.
Question: Over what period of time am I considering investing?
Answer: I’ll use a 1 year period because it aligns with many investors own review period.
Fixed-rate XTBs are usually bought as a buy and hold security, which allows investors to earn the yield to maturity (Yield or YTM1) the security was trading at on the day they bought the XTBs.
But, one benefit of XTBs is that investors can buy and sell them on the ASX any trading day and at the prevailing market price. Therefore, if after a period of time an investor wants to rebalance a portfolio – they can.
Question: What will happen in one years’ time?
Answer: This answer can have many variables, but for this example I will assume only two scenarios.
- Scenario 1: Nothing changes, the RBA stays on hold and Yields stay exactly the same. Also during the year, the BBSW benchmark does not change.
- Scenario 2: In exactly 1 years’ time, the RBA cash rate increases by 0.50%. XTB yields also increase by 0.50%.
Question: What is the Total Return of XTBs over the period under each scenario?
Answer: The Total Return of an XTB is the gain you have made from investing in the XTB for the period measured (i.e., you sell it after a year rather than hold it to maturity).
Total Return takes into account the coupons received (income return) and the change in market value (capital return) of your XTB. If you held it to maturity the capital at maturity is the face value of $1002. However, if sold early, you will receive the prevailing market price.
The prevailing market price in the future can be calculated if you know the yield to maturity. I use the expected future YTM as a model input.
Using the model: Compare two XTBs: YTMF04 and YTMDOW
|Reference Issuer||National Australia Bank||Downer Group Finance PTY|
|Maturity||08 NOV 2018||29 NOV 2018|
|Coupon||3 month BBSW + 0.88%||5.75%|
|Traded Margin||3 month BBSW + 0.30%||N/A|
Source: Bloomberg & Australian Corporate Bond Company
Scenario 1 – No change to the RBA cash rate
- The total return of YTMF04 would be 2.09% after 1 year
- The total return of YTMDOW would be 3.26% after 1 year
(For simplicity, in this model I have reduced the number of calculations and have assumed coupons are not reinvested, so the actual total return is lower than the YTM).
With no change in rates an investor would be better buying the fixed-rate XTB.
Scenario 2 – 0.50% increase by the RBA
- The total return of YTMF04 would be 2.02% after 1 year.
(There is a small drop in returns because there is an existing coupon that gets repriced. Consider this as equivalent to breaking a 3 month term deposit if rates change).
- The total return of YTMDOW would be 2.94%.
So even with a 0.50% rise in the cash rate, under my model an investor would still have been better off with the fixed-rate XTB.
‘What if’ scenario
Question: What increase in yields after 1 year is required to generate a 2.09% total return for YTMDOW. i.e. how much would the yield have to increase (price falls) to give you the same total return as the floating-rate XTB.
Answer: A 1.82% increase in yields would be needed over the year period.
It is important to note the following:
- Longer dated XTBs would be more negatively affected by the change in interest rates. Therefore, with longer dated XTBs for the same change to the cash rate by the RBA, a larger decrease in total return would occur.
- I assumed the fixed-rate XTB yield moved exactly the same amount as the RBA cash rate increase, and this may not be the case.
- The market pricing of ‘credit’ (corporate bonds) from time to time can also affect the pricing of XTBs and this has not been factored in.
Even in a rising rate environment, a fixed rate portfolio can be constructed that makes sense for investors. Using XTBs you can create a fixed income portfolio that suits your needs and views on the market. Floating-rate XTBs have ultra-low volatility and advisers may look at those XTBs as an alternative to cash management investments, or cash held on platforms.