Last week we published part 1 of our two part series on fixed rate bonds and rising interest rates. In that article we covered points 1 and 2 of the five things you should think about when considering corporate bonds in a rising rate world. Now we turn our focus to the remaining 3 points.
Five key things you should think about when considering corporate bonds in a rising rate world:
- Bond tenor and duration risk
- When will rates rise, and are you holding to maturity?
- The benefits of higher yielding fixed-rate XTBs over floating rate TDs – carry.
- The Maturity Ladder approach – holding fixed-rate exposure, but where rate increases are your friend.
- Floating-rate bonds.
3. The benefit of higher yielding fixed-rate bonds over floating rate TDs – or carry.
Previous analysis we conducted looks at a range of rate scenarios and compares the Total Return (income and capital) from staying in TDs, versus investing in XTBs, which generally have a higher yield than TDs. The gist of this analysis remains valid today. It shows that the fixed-rate investment is the better investment in most scenarios except for a reasonably aggressive rate hike scenario. The reason for the outperformance is the higher yield. The analysis underlines the benefits of higher yields (greater ‘carry’), over floating rate returns achieved from rolling over short-dated TDs in many scenarios.
This also underscores, the trade-off you need to consider in terms of when the cash rate will increase and by how much it will increase, over a known timeframe. Just sitting in TD world and waiting to see what will happen can create an opportunity cost to you. If you waited a year in TDs to see if rates will increase, and they don’t, then you’ve lost the benefit of higher yields in the meantime.
4. The Maturity Ladder – holding fixed-rate bonds, but where rate increases are your friend
This may be hard to fathom because we know fixed-rate bonds should drop in price when yields increase. However, this strategy is widely known in the US as a means of using the particular features of bonds and rising rates to your advantage.
The Maturity Ladder takes advantage of the fact corporate bonds will mature at par value, or $100. It doesn’t matter what rate rises have occurred before the bond matures, it will mature at $100 with the primary risk being a corporate default. This approach can be used if investors are strongly of the view rates will rise over a period.
Let’s look at an example over a 7-year period
Most people agree over this timescale rate rises are highly likely.
- You buy XTBs that mature in each of the years of the 7 year period, with an even split of your portfolio across the 7 XTBs.
- You now have income from 7 bonds, with capital also coming back to you each year for the next 7 years.
Assume the RBA starts lifting the cash rate from mid-2018 by 25 bps. Let’s also assume they keep increasing it every 4 months at that rate for 5 years. This would result in a 3.75% increase in the cash rate to 5.25% by mid-2023.
Not your typical perfect time to have bought fixed rate bonds, or so you’d think.
- You bought your 7 bond portfolio in July 2017.
- The first bond matures just after the RBA makes the first increase. But of course that doesn’t impact the $100 per XTB you get from maturity.
- You then roll this capital into a new 7-year XTB (your old 7-year XTB is now the 6-year XTB in your portfolio).
- The new-7 year XTB is definitely impacted by the rate increase before you buy it. This means you can purchase the new XTB at the prevailing higher yield (it’s now cheaper).
Under the Maturity Ladder approach investors are receiving interest rate-impervious capital and reinvesting it in cheaper and cheaper bonds as rates are increased. In fact, investors are actually hoping for more rate rises. The Maturity Ladder approach is a way of turning an apparent weakness into a strength.
Remember you do need to hold to maturity. If you wanted to sell the XTBs, the longer-dated they are the more they will be negatively impacted by the RBA rate increases. But, if you can hold to maturity, this is a great way to keep earning good returns from fixed-rate bonds. Read our previous article which applies this thinking to investors in both pre-retirement and post-retirement circumstances and some related thinking about how to use this powerful technique.
5. Floating-rate XTBs
About 20% to 25% of XTB flow in the last two years has been in floating rate XTBs. We understand that a great deal of this volume is using floaters as an alternative to cash management because of the ultra-low volatility they exhibit. But some investors may not hold to maturity, in which case they want to take interest rate risk off the table. The Maturity Ladder approach and comparing relative returns from fixed-rate bonds versus floating investments are both great ways to generate competitive returns from fixed-rate bonds. But some investors prefer the simplicity of investing in floating rate XTBs and with ten floating-rate XTBs over senior floating rate bank bonds, there’s plenty of choice, so they don’t need to focus on the cash rate.
If rising interest rates meant fixed-rate bond markets shut down until the next rate-cut cycle, then this global market would have died out years ago when floating rate bonds were introduced. This part of the bond market has been around for centuries because there are investing techniques that enable investors to keep generating returns in rising and falling rate worlds.