Interest rates key to assessing risk-reward comparisons
There is a broad consensus that rates around the world are rising. The cash rate set by the RBA is on hold, but the US has been lifting rates and US Treasury yields have come off their lows.
Add to this an environment where many Australian investors are significantly overweight shares and the risk of capital losses in the event of a large equity correction is high.
Now could be the time to take some of the profits from equity markets and rebalance your portfolio to include an allocation to more defensive corporate bonds. This may help to preserve capital and ensure a regular and predictable income stream, something many retirees focus on.
Corporate bonds can offer slightly higher returns than bank term deposits in return for the step up in risk of loaning money to a corporate rather than a bank.
Although corporate bonds do not enjoy the benefit of protection under the Financial Claims Scheme that many term deposits do, they can provide a yield uplift of up to 50 per cent.
[Source Canstar: $10,000 term deposit for three to six months from a top four bank. Australian Corporate Bond Company best available XTB (exchange-traded bond) yield, 30 April 2018.]
This can make a significant difference for investors, given the declining term deposit rates of recent years. And by sticking to ASX 100 companies, the additional risk of bonds can be minimised.
Read more about how Term Deposits compare to XTBs
Like any investment, one in corporate bonds carries some risk, particularly that of default by the issuer. But their position in the capital stack (bonds get repaid before hybrids and equity in a default) and the quality of the issuer can go a long way to mitigating this risk.
Find out more about the risks of investing in XTBs.
Investment risk / return spectrum
Types of bonds
Bond investors generally buy them to generate a regular and reliable income and, if held to maturity, the return of the face value. Bonds can provide greater certainty than equity from the same issuer. There are two main types of bonds, fixed and floating, and they can play a different role in your portfolio.
For both, the total return is made up of two components:
- The interest paid (coupons) during the life.
- The change in price of the bond.
Fixed-rate bond coupons are known throughout the life of the bond. In Australia, coupons are generally paid on a half-yearly basis. Over time the price of fixed-rate bonds can fluctuate to reflect market interest rates.
Bonds can trade at premium or discount to the face value, depending on whether the market interest rate is lower or higher than the coupon rate. This can impact on the yield investors receive. A bond trading at a premium, all other things being equal, generally has a yield that is lower than the coupon rate.
As bonds move towards maturity their price will trend towards the $100 (the face value) that is returned to investors at maturity (subject to there being no default by the issuer).
The effect of market interest rate changes on a bond’s price tends to be a function of the time to maturity. As shorter-dated bonds are closer to their maturity date, the price are less affected by rate changes than longer-dated bonds.
Investors concerned about the effect of interest rates should look to bonds with shorter-dated maturities; three to five-year corporate bonds are a good place to start.
Floating-rate bonds (floaters) have a variable rate that resets periodically, usually at the start of the coupon period. In Australia, floaters tend to pay coupons on a quarterly basis, which means the interest rate resets every three months.
Typically, they track the 90-day Bank Bill Swap Rate (BBSW), which rises (and falls) roughly in line with the cash rate.
Floater coupons are usually based on BBSW plus an added “spread” known as the Initial Margin.
- A floating-rate bond is issued with a face value of $100 for three years and a coupon of “3‐month BBSW + a margin, e.g. 1 per cent”.
- Coupon payments will increase if BBSW rises, or decrease if it falls.
- Three-month BBSW currently stands at 2.04 per cent, making the example rate 3.04 per cent in the current coupon period.
- The coupon rate changes on each reset date as BBSW fluctuates throughout the life of the bond. The Initial Margin (the “1 per cent”) stays the same.
This variable coupon has the effect of preserving the capital value of the bond, so floaters tend not to be as sensitive to a rate change as fixed-rate bonds.
When will rates move?
ASX trading in futures contracts shows that the professional market currently thinks the RBA cash rate will change by 25 basis points around August/September 2019. This ties in with the RBA’s comments about lack of inflation or wage pressure.
Is this the time to focus exclusively on floaters?
There has been much talk in the media that now is the time to invest in floating-rate bonds as their coupon rates (interest) will rise as interest rates rise. Their lower price volatility makes them a good consideration for investors who are uncertain when they will need their funds and therefore may not hold bonds to maturity.
However, if you are looking to invest for a set period and expect to hold until maturity, there are some further questions worth considering before opting exclusively for floating-rate bonds over fixed.
- Coupon rates for fixed-rate bonds can be higher than those for floaters, so it is important to consider which will provide the better return.
- On the one hand, floaters offer more uncertainty of returns than fixed bonds. On the other, they generally have smaller price movements in response to interest rate changes.
It is also important to remember that with floaters there is nothing to gain if there is a surprise in the market and interest rates fall further. Essentially the same is true if rate rises do not happen as quickly as expected. The media has been talking of “imminent” rate rises for the past 18 months, yet the market still thinks the next rise is 15 months away.
A fixed-rate strategy to consider
(Editor’s note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a financial adviser before acting on themes in this article).
For investors who want the greater predictability and higher coupons of fixed-rate bonds, the next step is to look at which ones to buy. Those that are closer to maturity are impacted less by changes in interest rates.
So, bonds with no more than five years to maturity are a good place to start.
Investors looking for just one bond in which to invest have access to a broad range of individual fixed-rate XTBs on ASX.
For investors wanting to develop a portfolio of bonds, a fixed-rate strategy worth considering is called building a Maturity Ladder.
This is how it works:
- Buy five XTBs over five ASX 100 company bonds with one maturing in each of the next five years.
- Assume that from mid-2019 the RBA increases rates over the next five years.
- The first XTB matures in 2019. The rate increase does not impact the $100 face value received.
- Roll the $100 into a new five-year XTB. Its market price is now lower because the RBA lifted rates, so the yield is higher.
- The second bond matures in 2020 and the RBA has raised rates again.
- Again there is no impact on the $100 face value. Roll this into a new five-year XTB, which is likely to have higher yields.
With this approach investors can mitigate the impact of future rate rises – it turns an apparent weakness into a strength, depending on the speed and magnitude of rate rises. Note: You need to hold each bond to maturity for this to work.
As with all investments, diversification reduces risk. If you are uncertain about rates and do not know how long you can invest your money, floating-rate bonds could be a good approach.
However, if you have an investment timeline in mind, it may be better to carefully select a portfolio of fixed-rate bonds to build a Maturity Ladder portfolio. Of course, a combination of the two approaches can often be the best way to go.
- Maturity Ladder Portfolio
- Cash Flow Tool
- Available XTBs – Interactive Table
- Fixed vs Floating – Is it time to float away with bonds?
This article first appeared in ASX Investor Update 08 May 2018: View on ASX