Treasury managers who are dissatisfied with the low returns available through cash and term deposits are discovering the advantages of investing in investment grade rated bank bond and floating rate note (FRN) assets. Our Managed Income Portfolio Service (MIPS) Director Emma Jenkin answers some frequently asked questions and discusses investment strategies offered by MIPS
Treasury managers who are dissatisfied with the low returns available through cash and term deposits are discovering the advantages of investing in investment grade rated bank bond and floating rate note (FRN) assets. These assets deliver a significant uplift in yield and add a level of improved liquidity, thus offering a viable investment alternate to cash and term deposits.
Here, Emma Jenkin, Director within FIIG’s Managed Income Portfolio Service (MIPS), answers some frequently asked questions regarding this opportunity. She discusses example portfolios and the advantages of executing this investment strategy through the Individually Managed Account (IMA) platform offered by MIPS.
Q: Why are clients moving out of cash and term deposits?
Domestically, interest rates paid on cash deposits and term deposits are very low. Cash will yield the lowest, but is the embodiment of liquidity. However, term deposits have no liquidity other than at maturity. Investors extending the term to maturity of deposits to earn a higher yield subsequently face liquidity management issues.
Q: What alternatives are available?
An easy first step for investors is to consider bank bond and FRN issuance of the bank’s that they would otherwise be lending to via at call cash or term deposits. A second step is to consider investing in the same products from the complete universe of bonds and FRNs issued by all Australian banks.
FIIG’s Managed Income Portfolio Service provides professional fixed income management expertise of Individually Managed Accounts (IMA’s), and specifically has a dedicated focus on providing solutions within this asset sector. MIPS can customise investment mandates to enable investors to select exposure that is appropriate to their organisation’s risk, return and liquidity requirements.
Specifically for investors seeking to improve returns on cash, MIPS has developed four conservative Australian bank bond FRN programs that are available from a minimum subscription of $5m.
Q: What type of investor typically considers this strategy and why?
Investors include large and small companies, universities, not-for-profits, charity and faith based entities, and other organisations whose main goal is capital preservation.
Investment grade bank bond and FRN portfolios can complement cash investments, comprised of at call accounts and term deposits, collectively optimising returns whilst delivering superior liquidity.
Q: What is the return uplift above cash and term deposits that can be expected?
Australian bank bond FRN portfolios have entry yield levels commencing at 2.97% per annum, to as high as 3.63% per annum. Excess yield above 90 day term deposits starts at 0.47%, moving to as high as 1.13%.
Meaningful excess returns are generated by the MIPS Portfolio Management Team through active management. In the year ending 31 March 2017, the team added 1.05% gross to the return on the Major Bank Senior and Subordinate Program (Program 3). The methodology by which the MIPS Portfolio Management Team creates excess returns is examined in detail in "A Fixed Income Portfolio Manager’s perspective on ‘Yield Enhancement'".
Q: Why do Australian bank bond portfolios hold floating rate notes (FRNs)?
FRNs are the preferred product for the MIPS Bank Bond (FRN) Programs because they have minimal interest rate risk or duration* and within the fixed income universe they are the product that best replicates ‘cash’. The interest rate is reset every 90 days over the bank bill swap rate (BBSW) resulting in these securities tracking the prevailing short term interest rates of the day - the same short term interest rates that are the basis for rate setting of at call cash and term deposits.
The major bank FRNs represent a significantly large part of the corporate bond market with single issuance lines in excess of $500m common. Figure 1 demonstrates the billions of dollars of issuance by the banks.
Australian bank senior and subordinated bond issuance
Source: Bloomberg, FIIG Securities
AUD issuance only; total issued
These senior FRN assets, amongst others, are High Quality Liquid Assets (HQLA) under the RBA definition, meaning ultimately the RBA will support liquidity via repurchase agreements in all market conditions. The bid offer spread of FRNs is very narrow, typically a 0.01% spread in large volume, providing liquidity at tight entry and exit prices.
Q: What is the liquidity improvement above term deposits? How quickly can I access funds?
Liquidity for Australian bank bond FRN portfolios is estimated to be between two to five days in normal market conditions. Liquidity may extend longer depending upon percentage exposure mixes. Weekly turnover in the Australian corporate bond market is $5bn of a $510bn market of which bank FRNs make up a signficant part.
In comparison, term deposits are not liquid. An investor only receives interest and principal at maturity. There is no secondary market for term deposits.
Q: Can you summarise the example portfolio alternatives available and comment on the return and liquidity for each?
Source: Returns from FIIG cash desk as at 9 May 2017, MIPS Australian bank bond FRN as at 24 April 2017
For full detail see the Australian bank bond FRN programs
Q: What is the difference in risk compared to cash and term deposits?
- Bank deposits rank ahead of senior and subordinated bonds and FRNs in a default scenario. So, by investing in floating rate notes, there is a slightly higher risk of non repayment should the bank default. In the major bank portfolio, default risk is extremely low as evidenced by senior debt typically being AA- rated.
- Lower bond or FRN prices, at the time an investor wants to sell. This is a liquidity risk and is the possibility that the price of the FRN has fallen as a function of the credit spread being wider. This risk is mitigated by the pull-to-par of bonds*. Tighter credit margins are also possible at the time liquidity is required, and this will deliver a higher FRN price.
- Changes in interest rates can impact bond prices. This is known as duration risk. This risk is minimal in these portfolios as the maximum term exposure for FRN securities is 90 days – the date of the next interest rate reset.
- Total return risk. FRN’s reset every 90 days, while term deposits deliver a fixed return for a fixed period. If interest rates rise, FRN’s will reset at constantly higher yields ,, whilst term deposits will not. Locking funds away for long periods can be a disadvantage if interest rates rise. Conversely if interest rates fall, income from FRNs will also fall.
*As an FRN approaches maturity and the risk of the issuer not re-paying, declines, so too does the credit margin at which the asset trades. A declining credit margin delivers a higher asset value. Pull to par is discussed at length within the article titled “A Fixed Income Portfolio Manager’s perspective on ‘Yield Enhancement'”.
The Australian Bank FRN market assists portfolio optimisation by providing opportunities for investors to increase yield and improve liquidity. These investment strategies are widely implemented in international markets. There is additional opportunity to add meaningfully to the book value entry yields through active management.
A more thorough analysis can be found in “A Fixed Income Portfolio Manager’s perspective on ‘Yield Enhancement'", a paper written by Kieran Quaine, Head of MIPS.
Duration or Modified Duration
Modified duration is a measure of a portfolio’s sensitivity to movements in interest rates. Modified duration is the percentage change in a bond's price for a 1.00 percent change in whole yield curve. For example, a portfolio with a three year duration would lose 3% if that interest rate curve moved up by 1% across the whole curve. Conversely, a 1% downward move across the curve would result in a 3% gain.
Floating rate bonds (FRNs)
Floating rate notes are bonds that have a variable coupon, equal to a reference market base rate, like 90 day bank bill swap rate (BBSW), plus a margin. The majority of FRNs have quarterly coupons, that is pay interest every three months.
The price or margin that investors require over and above the benchmark BBSW rate.
Bonds that are classified as High Quality Liquid Assets (HQLA) by the RBA. The RBA provides liquidity for these bonds in all market conditions. Senior bank FRNs qualify as HQLA.
1Assumes no government guarantee as these are not retail deposits of $250,000 or less
2Assumes no government guarantee as these are not retail deposits of $250,000 or less