Wholesale investors focused on preserving capital can improve returns over cash and term deposits by investing in a portfolio of bank floating rate notes (FRNs).
Our largest institutions commonly invest in At Call Cash and Term Deposits (TDs) as a significant part of their defensive asset allocation and liquidity management strategy of their working capital. The Managed Income Portfolio Service (MIPS) Portfolio Management Team (PMT) have identified four key advantages derived through the addition of a bank FRN portfolio – issued by the same Australian Authorised Deposit-taking Institutions (ADIs) – in order to complement this strategy.
1. Bank Bond FRNs are higher yielding
ADIs rely on wholesale investors and can raise funds by issuing bank bond FRNs over varying maturities and structures. Banks reward these investors with a significant margin above cash and TD rates. Bank bond FRNs with longer maturities yield higher credit margins than those with shorter maturities. For investing in longer dated bank bond FRNs and taking term to maturity risk, investors can expect an annual yield advantage over TDs of up to:
Yield advantage of Bank Bond (FRN) Portfolios over five year TDs
Source: FIIG Securities. Bloomberg
Table 1
Figure 1
2. Bank Bond FRNs provide immediate liquidity
The majority of senior, highly rated bank bond FRNs issued by Australian ADIs are classed as High Quality Liquid Assets (HQLA) by the Reserve Bank of Australia (RBA). These, and other ADI-issued bonds, are extremely liquid and can usually be sold immediately for a T+2 day settlement. This is unlike TDs where the investor must wait until the TD matures to access funds, unless they are prepared to provide 31 days advanced notice and suffer significant early break costs.
3. Bank Bond FRNs offer portfolio diversity
Australian banks continually issue highly rated fixed and floating rate notes of varying maturities. In 2017, over $500bn of senior bank bond FRNs was issued in AUD. Given the volume of issuance, investors are able to diversify their exposure to individual banks, maturities, coupon type (fixed or floating) and across the capital structure (senior or subordinated) in order match credit rating, cash flow and other investment requirements.
4. Low volatility in Bank Bond FRNs
The price of a bank bond (FRN) can deteriorate when the credit margin widens, due to a perceived or real change in the bank’s creditworthiness. Since 2013, bank bond FRNs have shown little negative volatility in credit margin change for two reasons:
- The market has confidence that the issuing ADI will retain its highly rated investment grade status.
- The Australian Prudential Regulatory Authority (APRA) has enforced higher capital standards resulting in improved ADI credit worthiness. Subsequently, credit margins have rallied, meaning they have fallen.
Regardless, when examining credit margin negative volatility, investors exposed to a portfolio of bank bond FRNs can afford sizable credit margin deterioration over the first year of holding and still break even compared to holding TDs of a similar maturity. The advantage becomes significant at and beyond the three year maturity range as evidenced in the Table 2.
Amount the credit margin can widen before a TD outperforms a Bank Bond (FRN) Portfolio
Combine for an enhanced strategy
TDs provide certainty in cash flows and capital preservation given deposits of up to $250,000 are guaranteed by the Australian government when placed with an Australian ADI. FIIG’s Short Term Money Market Team (STMM) is able to provide an optimised solution for an investor’s cash and TD investment mandate by matching deposit size, ratings, rate, term, duration and allocation limits against the largest universe of eligible investment options available.
While the STMM team are constantly reinvesting and finding the best solution for cash and TDs in the zero to two year maturity range, the MIPS PMT can simultaneously construct and manage a bank bond portfolio in the three year plus maturity range given the investor’s credit, maturity and liquidity requirements.
Cash, TDs and bank bonds are all highly rated, investment grade products offered to wholesale investors by Australian ADIs. By adding a portfolio of individually managed bank bonds to a working capital investment strategy, investors can retain the certainty of cash flow, while improving yield and offering immediate access to more of their funds.
For further advantages, risks and discussion on how a bank bond portfolio can benefit your strategy, please see A Bank Bond Portfolio – the return and risk equation.
For more information, please call 1800 01 01 81.
Notes
A customised bank bond portfolio managed by the MIPS Portfolio Management Team is available to Australian wholesale investors with a minimum investment amount of $5,000,000. An At Call and Term Deposit strategy managed by the STMM team requires a minimum investment amount of $1,000,000.