The RBA has explicitly stated that it is open to cutting cash rates as early as June 2019, so what does this mean for fixed income investors?
The recent minutes from the May RBA meeting as well as the speech by Governor Philip Lowe titled “The Economic Outlook and Monetary Policy” clearly indicated that the RBA has moved to an easing bias. The last few words from Governor Lowe’s speech were “A lower cash rate would support employment growth and bring forward the time when inflation is consistent with the target. Given this assessment, at our meeting in two weeks' time, we will consider the case for lower interest rates.”
Following the speech, many economists (including the four major banks) amended their rate cut expectations to one cut in June 2019 and a second cut in August 2019, following the release of inflation figures that continue to remain weak.
The likelihood of rate cuts has received wide press coverage, including the impact of any cuts on deposit and home loan rates, but what does it all mean for fixed income investors? Here we take a look at the three main fixed income security types – fixed coupon bonds, floating rate notes (FRN) and inflation linked securities.
Impact on various security types
The inverse relationship between bond prices and interest rates is well known. When rates or yields fall, bond prices move higher. At the beginning of the year, we noted that investors should move to longer duration bonds. These bonds have benefitted the most from a fall in yields. As illustrated below, 10 year Government bond yields have fallen significantly over the course of 2019 to their lowest historical levels.
Source: Bloomberg. Data as of 24 May 2019.
This is also the case for the 3 month BBSW (3mBBSW), which is the benchmark rate used for most FRNs. The chart below clearly shows that since Governor Lowe's speech on 21 May the benchmark rate has moved lower as the expectation of a rate cut has increased. The 3mBBSW is now at its lowest historical rate of 1.44%. It is unlikely that the benchmark rate will move much lower unless the RBA cuts rates more than two times in this cycle i.e. rates fall below 1.00%.
Source: Bloomberg. Data as of 24 May 2019.
When market participants say that a rate cut is “priced-in”, they are referring to a downwards move in yields and benchmark rates, which usually move lower ahead of an official cut in RBA cash rates. Below we summarise the impact of these moves on the three different security types.
Fixed Rate Bonds
Generally speaking, fixed rate bonds perform well when interest rates are falling, however this is highly dependent on the credit quality of the bonds
Investment grade (IG) bonds – IG bonds (especially higher rated bonds) with longer duration will benefit from any further move down in yield curves. However, this is likely to be relatively muted given yields have already moved lower. As we have noted on a number of occasions, IG bonds should have a strong allocation in any bond portfolio.
High yield (HY) bonds –The majority of HY bonds are issued with fixed coupons. HY bonds are relatively riskier when compared to IG bonds, however they provide strong coupon income in a well-diversified portfolio. The higher credit spread in HY bonds means these bonds are not as sensitive to moves in yield curves.
Floating Rate Notes
FRNs provide portfolio protection in a rising rate environment, however as rates fall, more and more issuers choose to issue FRNs to reduce their funding costs. This is not to say that investors should not include any FRNs in their portfolio in the current environment. The coupon on an FRN is the benchmark rate plus the coupon margin, which is a proxy for credit risk. FRNs have a very short duration as the coupon on an FRN is reset either monthly or quarterly. This also means that in most cases the price of an FRN does not move too far from par unless there is a material change in the credit quality.
There are a number of reasons why portfolios should include FRNs despite low interest rate expectations. Firstly, FRNs provide portfolio diversification and will protect investors from any rate shocks. This is important in the current environment which is dominated by market volatility. Secondly, there are a number of securities that are only issued as FRNs. Most bank issued paper, including Tier 2 securities and Residential Mortgage Backed Securities (RMBS) are only offered as FRNs. Therefore, FRNs allow investors to achieve diversification by sector as well as security type.
Inflation Linked Securities
One of the primary reasons for the RBA to cut rates has been subdued domestic inflation. By lowering interest rates, the RBA is hoping to stimulate the economy and thereby increase inflation. This is a positive factor for investors holding inflation linked bonds or annuities, which usually have long maturities and should benefit from a pick up in the underlying inflation. Furthermore, the real rate of return on these securities, which derive their cashflows from government linked projects, is also quite attractive. Please refer to our guide to understand how inflation linked securities work.
The RBA has clearly flagged that rate cuts are coming. We, like most fixed income market participants, believe that the impact from rate cuts is already priced in, meaning there should be limited price movement from hereon of rate cuts. We continue to endorse portfolio diversity, in terms of both the ratings and the security type. While fixed rate bonds should perform better than FRNs or inflation linked securities in the current environment, all three security types have a place in a balanced portfolio for the reasons outlined above.
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