Monday 07 August 2017 by Elizabeth Moran Opinion

Why buy fixed rate bonds when interest rates seem to be rising?

As published in The Australian on 5 August 2017

It might seem like the worst possible time to lock in a fixed rate of return when interest rates are rising, but for astute investors it can still make sense

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Bond prices are partly based on forward projections of expected interest rates. Usually forecasts are for interest rates to rise over time, giving investors reason to save and invest, and invest for longer periods to increase returns. This produces a ‘normal yield curve’ - you get paid more for investing for longer. 

However, the market doesn’t always get it right. It might overstate rises, or there may be no interest rate rises at all. In that case investors in fixed rate bonds will be rewarded. Forecast future interest rates will come down and push fixed rate bond prices higher, delivering higher than expected returns to investors.

Much depends on your expectations for interest rates and if you think forecasts are accurate.

Over the last year , interest rate expectations have changed dramatically, making 10 year Australian government bond yields relatively volatile. The Brexit vote caught the market unaware and forward expectations of interest rates declined after the vote. Roll forward five months to the US presidential election and Trump’s shock win on the basis of big tax cuts and massive infrastructure spending sent interest rate expectations up like a rocket. 

Aside from the market just calling the outlook wrong, there are a few other points worth noting:

1. Interest rate changes take the elevator down but the steps up

Central banks need to balance three key objectives: employment, growth and inflation. One of the ways they do this is by changing central interest rates. If interest rates are too high, consumers avoid spending and borrowing and an economy can tip into a recession. In this instance, central banks cut rates quickly – they don’t want a recession.  Equally, when an economy is recovering from the stimulus of low rates, central banks are nervous, not wanting to raise interest rates too quickly, so increases are typically slow, so the central bank can measure the impact. Thus the saying, down by the elevator and up by the stairs. 

For example, in September 2015, the US Federal Reserve median rate forecast was for a Fed funds rate of 0.4 per cent in 2015, 1.4 per cent in 2016, 2.4 per cent in 2017 and 3.3 per cent in 2018. Its more recent June 2017 forecast is for a 1.4 per cent rate by the end of 2017, and a 2018 projection of 2.1 per cent.

2. Corporate fixed rate bonds are less sensitive to interest rate changes than government bonds

The most interest rate sensitive bonds are those that are lowest risk, such as government bonds. Returns on these instruments are almost entirely correlated with future interest rates expectations. They also tend to be the focus of most commentary, but rarely do we see individual investors choosing to invest in those markets.

Corporate bonds which include a premium for credit risk – the risk associated with the company – and pay higher returns than government bonds. The addition of credit risk premium, known as a credit spread, means that corporate bonds are typically less sensitive to interest rate changes. The higher the company risk, the higher the credit spread and the less the price will be influenced by interest rate changes.

3. Ultimately, many investors want reliable income

Large investors such as universities, charities and government councils need to have certain cashflows to cover expenses, as do retirees. Knowing future cashflows helps them plan ahead. Fixed rate bonds deliver fixed returns for the life of the bond.

One of our favoured Australian dollar fixed rate bonds is by residential mortgage supplier, Liberty Financial. This investment grade bond matures in June 2020 and has a current yield to maturity of 4.5 per cent per annum.

4. Yield differences between fixed and floating rate bonds

Floating rate bonds pay interest which is tied to a benchmark and adjusts to market expectations every quarter, and therefore investors may prefer these bonds if they think interest rates will rise. But, at the moment, there seems to be very little difference in yield when you compare fixed and floating bonds issued by the same company maturing at the same time. 

For example, Asciano has a longer dated fixed rate bond and floating rate bond, both maturing in May 2027. The fixed rate bond shows a yield to maturity of 4.66 per cent per annum, while the floating rate option is only slightly higher at 4.69 per cent per annum. The implication for now is that investors see little added benefit of the floating rate option at this point in the cycle.

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