With economists forecasting rate cuts to never before seen levels this article discusses how best to adjust your portfolio
Leading Australian economists are forecasting a further 50bps cut to the cash rate in 2015 taking it to just 2%, a level never before seen here. Deutsche Bank, Westpac and Goldman Sachs have all revised their outlooks and are now tipping two 25pbs rate cuts in 2015 as the RBA seeks to bolster domestic demand and lower the Australian dollar due to rising unemployment, on-going declines in commodity prices and an expected slow-down in the housing market.
A 2% cash rate implies lower growth and lower returns for investors across asset classes. Returns of over 6% p.a. are considered high yield and high risk and if your aim is to increase return, you will need to invest in higher risk companies or invest for longer periods.
The deteriorating outlook reinforces the themes of global and Australian interest rates remaining ‘lower for longer’ and the continued weakening of the Australian dollar. If you believe these themes will remain here are some strategies to profit from these trends.
1. Reduce cash and term deposit holdings or lock in longer terms
If rates continue to decline the outlook for deposit rates is very poor. Don’t just sit on cash waiting for something to change. You may be waiting a long time. A diversified bond portfolio is paying roughly twice the return of cash which can make a significant difference to income received.
2. Extend duration (moderately) on short dated fixed coupon bonds
Very short dated fixed coupon bonds (less than two years to maturity) are at a point where there is virtually no room for outperformance in these securities, even if rates fall. Switching this exposure to moderately longer dated fixed coupon bonds (3-6 years) will enhance the performance of the portfolio, particularly if you select bonds with higher credit margins.
This strategy applies to most fixed coupon bonds maturing in less than two years. Some of the more common short dated fixed coupon bonds that our investors hold are:
- Rabobank 31Dec14c
- Rural 12Feb15c
- Telstra 15Apr15
- MSDW 26May15
- AAI 07Sep15c
- DBNGP 29Sep15
- ING 22Mar16
- DBCT 09Jun16
- National Wealth 16Jun16c
Options to consider moving into include PAYCE 2018 (with first call 2016), Adani Abbot Point 2020, Mackay Sugar 2018 or Lend Lease 2020.
3. Replace low margin floating rate notes with higher margin floating rate notes or inflation linked products
Until short term rates rise significantly, floating rate notes will continue to be a drag on income unless the margins on those bonds are high enough to compensate for the low nominal short term interest rates. Many of these securities are relatively short dated, so it is unlikely that we will see short term rates rise significantly before the bonds mature (or are called).
There are a few (although not many) longer dated floating rate notes with higher margins that these bonds could be switched into; however, most of these bonds are available to wholesale investors only. An alternate strategy would be to convert this exposure from floating rates to inflation linked. Given short term rates are at 2.5% (and possibly falling) and the midpoint of the RBA inflation band is 2.5%, the situation is supportive of linking your income to inflation rather than short term rates. Moreover, many of the inflation linked products available are trading at attractive margins to CPI.
This strategy applies to many low margin and/or short dated floating rate notes. As noted above, there are a few choices for higher margin floating rate notes for wholesale investors but not many for retail investors. The range of available inflation linked products is somewhat broader.
Some of the more common low margin and/or short dated floating rate notes that our investors hold are:
- Rabobank 31Dec14
- Telstra 2016
- ING 22Mar16
- MSDW 22Feb17
- NAB 28Nov17c
- AMP 21Dec17c
- BOQ 10May16c
Options to consider moving into include the Swiss Re 2017 or G8 Education 2017 as higher margin floating rate notes, and Sydney Airport 2020 as a higher margin inflation linked product.
4. Gain exposure to the USD
The IMF, World Bank, OECD and most of the G20 central banks are forecasting that the US economy will grow faster than the G20 average for the next 2-3 years at least. The USD therefore should perform against the AUD especially if Australian interest rates are cut. In fact, implied USD longs by international money market traders is at record high levels of 71% of open interest – meaning most investors are long US dollars - while investors are also long US dollars against every other currency.
The simplest way to profit is to be “long USD”, that is to have a direct exposure to US Dollars. You can do this through a US bank account (very low interest); US shares unhedged; or USD denominated corporate bonds. The latter strategy has been one our clients have been successfully using for some time with yields of 2-10% p.a. on top of the 9.59% rise in the USD in the last 12 months. This is also a strong hedge against the likelihood of falling equity returns when the global economy is slow.
Some companies will do well in a falling AUD environment, despite the slower economy particularly Australian corporates with an exposure to export earnings. Sydney Airport for example benefits from increased tourism traffic and to a lesser extent Perth or Brisbane Airports. Universities such as ANU may benefit from an increase in high fee paying international students. Similarly, exporters such as Mackay Sugar, Newcrest and Fortescue will also benefit from a lower AUD, although the falling commodity prices (in USD) may offset some of this benefit.
Conclusion
The outlook for growth in the Australian economy is poor. If the cash rate is cut further as various economists suggest, it will be even more difficult to find reasonable returns. Positioning your portfolio for even lower interest rates will help protect returns should the rate cuts eventuate.