Tuesday 10 July 2018 by Leigh Winton Trade opportunities

AUD Investment Grade – Extend maturity to improve yield

With the RBA unlikely to raise rates until at least mid 2019 we look at the opportunity to extend the maturity of AUD investment grade securities, to increase yield

extend

Recent talk in the press about rising interest rates is all focused on North America, where we have been suggesting clients own short to medium term USD bonds to minimise the impact of higher rates. This is because generally speaking, fixed rate bond prices decline when interest rates rise, as the excess return over government treasuries will decrease and an equivalent security issued today would have a higher coupon than one issued when rates were lower.

However, the situation is very different locally, with the RBA likely to be on hold for many months to come. Consequently, the low interest rate environment in Australia continues to pose a challenge for bond investors.

We suggest investors consider extending the maturity of their Australian investment grade bonds in order to take advantage of higher yields for similarly rated securities as we see the prospects of declining bond price due to increasing interest rates as low in the near term.

We also discuss our yield preference strategy, which focuses on yield to maturity (YTM) over investment in high coupon bonds that have low YTM but may offer higher running yield.

Background

For USD investments we have been suggesting clients own short to medium term maturity bonds as the interest rate environment in America is one of increasing rates, as its economy continues to expand and unemployment is below 4%.

However, we believe the interest rate environment in Australia is very different to the increases we see in the

USA and we believe that the RBA will keep rates on hold until well into 2019.

This is because the local economic outlook is substantially different, evidenced by a number of factors including increasing funding pressures for local financial institutions, wages growth being stubbornly low around 2%, and underemployment leading lots of excess capacity within the Australian labour market.

The interest rate and financial futures market believes this too, as evidenced by the higher forecast yields shown for short-term US rates compared with their Australian equivalent. This is shown in the chart below which uses Overnight Index Swap (OIS levels).

Projected future short-term rates for the USA and Australia (OIS Market; %)

 


Source: FIIG Securities, Bloomberg

All of these factors suggest to us that investors should extend the maturity of their shorter Australian investment grade bonds, and focus on the overall yield (to maturity) as opposed to the income or running yield.

Running yield or income from coupons

This is the coupon amount (expressed as a percentage) divided by the purchase price, and expresses the amount of cashflow from coupons generated by the bond.

If we use a 7.75% coupon and a price level of $115, the running yield is 6.74%, which is lower than the 7.75% coupon amount, reflecting the price ($115) is at a premium to the issue price of $100.

However, the fact that the returned face value amount at maturity is $100 which is a $15 dollar discount to the current price is not taken into account in this calculation.

For this reason, we prefer yield to maturity as a measure of potential investment performance as it provides a more complete picture of future cashflows.

Yield to maturity (YTM)

The YTM (or purchase yield) shows the overall return, incorporating the purchase price, the coupons earned and the capital ultimately received at maturity ($100 for a typical fixed rate bond). It is the closest yield to those shown for typical cash style products, albeit we have to make some adjustments to incorporate multiple cashflows from coupons and estimate the rate at which coupons can be reinvested.

We believe the YTM is a truer measure than the running yield as it is a more accurate reflection of the overall return earned including the purchase and sale price. This incorporates the total return across capital and income. In addition the YTM also considers the time value of money, i.e. when cashflows are received, and can be reinvested.

Case study comparison between two bonds:


Note: Yield accurate as of 3 July 2018, subject to change

Looking at the two bond cash flows shown above, the reader may at first glance prefer the higher coupons on the Qantas bond, but look again and notice the difference between todays invested amount of $115,000 compared to $100,000 returned at maturity.

Notice too, that the Asciano bond will provide you with five extra years of coupons, and although you will still receive a lower amount back at maturity than the upfront investment, it’s a substantial improvement on the Qantas position.

With the Asciano bond, there is also an increased face value amount representing an extra 10% holding, and although there is a small extra outlay of $2,000, this is largely because the Asciano minimum incremental change in face value is $10,000.

In this particular example, we believe Asciano provides a better investment option than Qantas, which will enable a pick-up in yield from 3.76%pa in Qantas to 4.59%pa in Asciano.

Investment suggestions

Given the rationale that we prefer maturity extension in Australian IG bonds, below are a few suggestions for investors to consider.

Shorter maturity bonds to consider selling



Source: FIIG Securities. Bid prices and yields accurate as of 4 July 2018, subject to change.

For callable bonds the lower of the yield to maturity and the yield to worst is shown in the tables.

Medium to longer term bonds to consider buying

Source: FIIG Securities. Ask prices and yields accurate as of 4 July 2018, subject to change

*based on a 2.50% CPI assumption

Conclusion

Since the interest rate environment in Australia is very different to the increases we see in the US, we believe clients should extend maturities in Australian dollar bonds, which is also known as extending duration or weighted average life.

If interest rates were forecasted to increase in Australia as steeply as in the US, we would feel differently about extending maturity, but we believe the structural obstacles for the RBA will remain for a considerable period of time.

One of the key differences between debt and equity is the fixed maturity date associated with a debt obligation.

Assuming the issuer is solvent at maturity of the bond, this not only gives the investor an added protection, but it means for simple fixed rate bonds that we can accurately model when the $100 face value will be returned. This ability to model all expected cashflows associated with a bond enables us to accurately calculate a yield to maturity, which we prefer to the running yield which only considers coupons.

Contact your relationship manager to discuss these and other opportunities.


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