This article was published in The Australian 9 May 2015.
Medium to long term, Australian domestic corporate bond yields have been rising becoming more attractive
The RBA cut to the cash rate last week and its lack of comment about future expectations has some commentators calling an end to the easing rate bias. The implication being that the next cash rate movement could be up.
Coupled with recent global government bond yields rising over the medium to long term, Australian domestic corporate bond yields have also been rising over the medium term, becoming more attractive.
The question then becomes, is now a good time to buy medium term fixed rate corporate bonds?
These bonds pay a known half yearly interest payment that is fixed until the maturity date of the bond. Because there is no other way to reflect changing expectations of interest rates, when expectations change the bond prices move up and down in the secondary market.
Future market interest rate expectations are already built into bond prices as both fixed and floating rate bonds are priced on the swap curve. Since the RBA cut the cash rate, expectations of longer term interest rates have risen, as shown in the graph below.
If interest rates rise more than expected in relation to the swap curve, then the price of the fixed rate bonds will fall, but the opposite is also true. If interest rates do not rise as much as forecast by the swap curve, then the price of your bonds should increase.
Source: FIIG Securities, Bloomberg
There are a couple of points to consider when deciding if medium term fixed rate corporate bonds are currently good value.
First, do you think the market expectations of rising interest rates over five to seven years as the swap curve predicts are accurate? If you agree, and remember this curve changes on a daily basis, you would be fairly neutral to investing in fixed rate bonds that mature over the same time frame.
If you expect interest rates to be higher, then you would not invest in fixed rate bonds, but you would be a keen investor in floating rate bonds, as their current pricing would not reflect much higher future interest rates and they would be considered ‘cheap’.
Investors that believe projected interest rates are too high, would consider five to seven year fixed rate corporate bonds good value.
Four fixed rate corporate bonds you might consider – from lowest risk to highest risk - are: Stockland maturing in November 2020 that pays a yield to maturity (YTM) of 3.84 per cent, Downer March 2022 with a YTM of 4.57 per cent, Alumina November 2019 with a YTM of 4.44 per cent and Qantas May 2022 with a YTM of 5.56 per cent.
A floating rate option is the infrastructure bond Dalrymple Bay Coal Terminal, maturing in June 2021 with a YTM of 4.75 per cent, but the bond is discounted, trading below its $100 face value, so a chunk of the return is provided at maturity. Income is lower and uncertain compared to the fixed rate bonds.
I am still of the view that interest rates will be lower for longer. While there have been some preliminary positive signs, I’d expect eventual rises in interest rates to be slow. On balance, compared to other investments, I think fixed rate medium term bonds represent a good opportunity. If interest rates did rise quickly, although prices would drop, investors would have the backstop of holding until maturity, being repaid capital and earning a positive return.
All of these bonds are higher risk than term deposits, but pay higher interest to compensate. The current best five year term deposit rate is 3.4 per cent, and this could be revised down by 0.10 to 0.15 per cent on Monday, as banks typically review term deposit rates on a weekly basis.
There are always two sides and it depends on your view of the global economy and your view of interest rates. Professional fund managers will diversify across all three types of bonds and with a range of maturity dates to provide protection, no matter what happens.
Note: Written prior to the Monetary Policy Statement released on Friday.