Learn more about which bonds are on the move with this weekly podcast. This week our senior relationship managers discuss US government bond yields and elaborate on terms commonly used in the bond market including the bank bill swap rate, call dates and yield to worst.
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Director, Fixed Income Sales
Jake grew up in Ottawa, Canada, where he rose from a teenage bank teller to a portfolio manager overseeing more than $600 million in assets for the Bank of Nova Scotia. With over twenty years in asset management he moved to Australia seven years ago with his family.
Director – Fixed Income
Stephen Mackie is based in the firm's Brisbane office, managing investments for clients, ranging from individuals to institutions.
Stephen has over 25 years' experience in global markets, including his most recent role at QIC where he was a Director - Investment Specialist in the Global Multi-Asset team. Prior to this, he has held a variety of senior roles as a trader and portfolio manager with RBC Capital Markets, Citi, Kapstream Capital and the Commonwealth Bank.
Director – Education and Research
Elizabeth has been with FIIG for ten years and for much of that time has been a corporate and bank analyst. In recent years her passion for education has seen her role shift, to author/ edit FIIG’s “The Australian Guide to Fixed Income” and an online fixed income course for Financial Advisers. She continues to edit FIIG’s weekly newsletter, “The WIRE”.
In her role as Director of Education, Elizabeth has delivered presentations at conferences across Australia. Prior to joining FIIG, Elizabeth worked as an Editor/Analyst for Rapid Ratings, writing daily press releases for Bloomberg. Elizabeth spent five years in London, three working as a credit rating analyst for NatWest Markets.
Elizabeth Moran: [00:00:00] Welcome to another edition of BondCast. My name is Elizabeth Moran, I'm Director of Education and Research here at FIIG. With me today I have Steve Mackie and Jack Koundakjian. Thanks for joining.
Both: [00:00:10] Hi Liz.
Elizabeth Moran: [00:00:13] Today I thought we would talk a bit about yields. So we're going to have a look at the US government bond yields to start and then some of the terms that we use here at FIIG that are pretty common to the market. And finally we’ll discuss some of the bonds in relation to some of those yields. But let's kick off Stephen with the US government bond yields. Can you just let us know what's happening there?
Stephen Mackie: [00:00:37] Yeah, sure Liz. So we've seen over the past month or so, a steady sell off in the price of US government bonds. So yields have popped above the 3% level. So we're up at around 3.25%. And looking forward, I think things look okay for the US economy. We had unemployment come out on Friday at 3.70%, which is pretty good. I mean the Fed… their mandate targets unemployment around 4.5 - 5%, so on all accounts, a big tick. They've got inflation anchored around that 2% level also. So really the Fed is sitting on a bit of a goldilocks economy but I think as bond investors we've got to look forward into the future, which is the tough part of our job.
So if you have a look at what the Fed expects, for the path of interest rates, that really drives what that 10 year government bond yield is over time. So if we roll forward two years into the future, which we can do as interest rate traders, and have a look where interest rates in the US are and in 2020 the market's expecting around 3%. So if overnight cash rates go up obviously bond investors need to be compensated for that. So there's what is known as a 'term premium'. So there's a bit of a pickup, you're lending money to the US government. So at the moment that term premium is picking up.
As you know, investors anticipate that they need to be compensated for future inflation. You know with your economy tracking along at such strong levels, it's understandable that at some stage workers in the US are going to put their hand up for a pay rise and that'll flow through to inflation. So that's really the US economic picture in a nutshell. So like him or not like him, the report card for Mr. Trump is looking pretty good on the bond front.
Elizabeth Moran: [00:02:32] So really as investors in Australia are we expecting our interest rates to follow the US up?
Stephen Mackie: [00:02:38] Well I think rising tides generally lift all boats. But what we have seen over the past, say twelve months is that US bond yields have gone a lot higher than Australian bond yields and that's actually been reflected in the currency.
One of a number of drivers for our currency is the yield pickup that investors get for buying an Aussie bond and typically commodity producing currencies have to pay a premium to attract investors into the country and that premium has been eroded by the US yields going up. So we're generally seeing that it's more efficient for US investors just to repatriate their funds back into US bonds and sell out of Aussie bonds. But that doesn't mean that Australian government bonds aren't still a good safe haven to park your cash. It just means that you're getting more in a US bond than we have traditionally.
Elizabeth Moran: [00:03:33] So really if we think interest rates are going to rise we would have a preference for floating rate bonds or notes - our clients would have that preference. Let's talk a little bit about the yields around floating rate notes. Jake do you want to talk about how you look at a floating rate note and what yield is of particular interest to you?
Jake Koundakjian: [00:03:55] Well, no one knows where the rates are going to go. They certainly have been rising and we've had a luxurious 10 years of really low interest rates. Ultimately rates go up because the glass is half full and rates go down because the glass is half empty and certainly based on what you're hearing out of the US economy, the glass is definitely half full and things are looking good and it's rosy.
That term goldilocks is not a term I've heard since pre GFC but I've heard it a few times recently. So rates go up when the world is getting good, rates go down when it is getting bad. If rates are going up, floating rates are definitely preferred. We've got quite a contingent, quite an offering of floating rate bonds out there. So if you do think the rates are going to rise, a floating rate will pay you a percentage over the Bank Bill Swap Rate (BBSW). Now, that's a bit of jargon in the marketplace, BBSW is what one bank would lend to another on a short term time frame and typically will follow what the Central Bank does but what we've seen in Australia is that the Central Bank has kept the rates at 1.5% and the BBSW hasn't floated upwards anyway. So its not really connected directly with the Central Bank rate. So if you do think that rates will continue to go upwards then you want to have more floating rate bonds overall. If you think they are going to go downwards, then you want to lock in a fixed pay.
Elizabeth Moran: [00:05:20] So with a floating rate bond and the income to me as an investor is reliant on what the BBSW is but on any given day that rate includes forward rate projections for the bond, doesn't it? So if in two years’ time they think rates are going to be 2.5%, it incorporates that base into the calculation. So when we talk about floating rate bonds or when you're shown pricing for floating rate bonds, it's dependent on that BBSW curve as at that particular day?
Jake Koundakjian: [00:05:54] Yeah. So the yield number that I see on a fixed pay bond or term deposit, I know what the return is, it's set in stone. You know when you get your distributions and how much they will be with a fixed pay... With a floating pay, when I see a yield of say 4.2%, that's a guess. It's a guess based on the projections into the future, what the markets expect, what the world is expected to do. So if the world becomes a worse place than what's expected right now, then rates ultimately will be lower than what is expected. If the world becomes a better place than what's expected, rates will be higher than that 4.2% that I see today.
Elizabeth Moran: [00:06:31] So that's our best guestimate, isn't it? And we were chatting about this, we were looking at some floating rate bonds earlier today. And I was looking at an IAG 2024 bond which I think you like, Stephen, as well. So it has a call date, yield to call. So we might often quote yield to call, do you want to explain that Stephen?
Stephen Mackie: [00:06:53] Yes, I think the important thing is to remember when we talk about floating rate bonds, whilst they don't have much interest rate duration, they do have credit durations. So if you buy a bond that's a three year floating rate bond, you still have exposure to credit spread. So if we see in the GFC credit spreads went wider, you will see that bond adjust in price and spread accordingly based on that movement in the credit spread. So that's two things for investors to really get their heads around with a floating rate bond. It's not necessarily less risk, it's just the risk comes from a different source.
Elizabeth Moran: [00:07:29] And you still of course have credit risk with fixed rate bonds as well.
Stephen Mackie: [00:07:32] Exactly.
Elizabeth Moran: [00:07:33] So yield to call is...
Stephen Mackie: [00:07:34] Exactly, so the yield to call on a floating rate bond, like any fixed rate bond is basically the yield to the first call date or the next call date that we think that the company will call their debt. So on a floating rate bond again it's expressed as a price. And if the company can fund themselves cheaper than when they issued that bond generally they'll call their debt in. So a lot of the bank subordinated bonds that are issued in Australia generally have call dates and a lot of them are called at the first opportunity.
Jake Koundakjian: [00:08:04] There is also reputational risk to not call on that call date. If you don't call away your bond on the expected date, the bond market will ask you to pay a lot more next time you come to the market place. So generally in the bond market when you say yield it's either yield to call or yield to maturity and generally with callable bonds you expect them to be called on that call date.
Elizabeth Moran: [00:08:25] There is also a yield to worst that we've started to quote more regularly now and I guess that's when there are lots of call dates and the worst possible return you can get if the bonds are called on that worst possible date. So I know some bonds, for example, might only have one call date but that others might have a call date and then every interest period after that until maturity is a call date. So there can be one to many call dates.
Jake Koundakjian: [00:08:54] Well, yield to worse is as it sounds, it's the return in the worst case scenario for your bond and typically with banks and insurance companies you're not going to have odd call pricing. But it's a very, very big universe out there and lots of things to consider and that's why you talk to us as fixed income experts to help you read through it to find the best opportunities and to watch out for yield to worst count.
Elizabeth Moran: [00:09:17] I think one thing I just want to talk about a little bit is yields are a really good indication of risk and I think we forget that. So higher yield overall means higher risk and lower yield, lower risk.
Jake Koundakjian: [00:09:31] Very black and white in the bond market, very black and white in the fixed income market. If you're earning 3% in a term deposit, that's because it's very safe. If you're earning eight, nine, 10, 12, 15, 27 percent... it's a very big universe with lots of choice but if you're taking more risk, you're getting paid for it, as long as you're comfortable managing that across your portfolio then so be it!
Stephen Mackie: [00:09:52] Yes, and that can be credit risk, liquidity risk... obviously larger bond issues have better liquidity. So you know things investors need to bear in mind when they're choosing their bonds…
Elizabeth Moran: [00:10:05] And certainly that's how we try and talking as an analyst now, we try and make a difference and the FIIG research team try to make a difference in finding the discrepancies or where we think the price and the risk don't add up and we think there are opportunities either to buy or it's time to sell... So I think that rounds up this week. Thanks very much for joining us.
Both: [00:10:25] Thanks Liz.