Tuesday 16 May 2017 by Kieran Quaine At FIIG

A fixed income Portfolio Manager’s perspective on ‘yield enhancement’

MIPS Bank Bond (FRN) Programmes – insights from a professional manager

Kieran Quaine, Head of FIIG’s Managed Income Portfolio Service (MIPS) answers frequently asked questions, candidly discussing the strategies that he and his team use to outperform. For calendar year ending 31 March 2017, the most popular bank bond FRN portfolio, comprised of senior and subordinate major bank FRN exposure only, achieved an impressive gross outperformance of 1.04% above book value entry, being 2.49% above the bank bill index return for the period. See Table 1.

Major bank senior and subordinated debt FRN portfolios

Table 1
Source: FIIG Securities
Note: Returns and benchmark data for the most popular of the example Bank Bond (FRN) MIPS Portfolio

Q. The outperformance delivered is impressive. Can you please explain outperformance in the context of this sector of assets?

Outperformance relates to the derivation of excess return above an alternate investment product. In the case of cash, the yield to outperform is that which cash returns. In the case of bank bills or term deposits (TDs), again the yield to outperform is that which bank bills or TD’s return.

Cash returns themselves should be segregated by the term of the cash lending agreement. ‘At call’ cash rates might vary as a function of the call limitations for example. ‘Special’ cash rates offered by banks from time to time may be available for short periods and to retail investors only, usually with volume caps.

But it is generally fair to say that the return to exceed for cash and cash like products that include bank bills and TD’s (of short maturity term – 90 days), within the professional wholesale investor space, is between roughly 2.00% and 2.50%.

The strategy must also consider risk. Risk considerations will include specific measurement of changes in liquidity, because after all cash is the embodiment of a liquid asset.

Q. Having determined a benchmark for cash and cash like products, what alternatives are available? Can you discuss the changes in risk and liquidity of those alternatives?

An easy first step for achieving returns over cash would be to look at the term deposit (TD) market. However, TDs are not liquid, and so require a commitment to a fixed term. TD’s have their place as a higher yielding cash alternative, but usually only in conjunction with other assets within a portfolio.

When attempting to improve cash returns, we need to consider products at a higher yield that keep liquidity. Fixed income products satisfy that criteria.  

A defining feature of fixed income assets is that they have known future cash flow profiles. At a product design level, they are an ‘extension’ of cash.

When an investor lends cash overnight, or for a week, they will be repaid interest and capital upon maturity, being the next day or the next week.  All fixed income products have the same key defining characteristics, being pre-defined and legally binding agreements for repayment of interest and capital on future dates. They also have the added benefit of also being ‘marketable’ securities, or transferable assets, meaning they can be traded prior to maturity.

The dominant borrowers in the cash market are banks. The same banks issue fixed income products. Subsequently an investors credit risk can remain the same where lending via a cash, bank bill or TD product is substituted with lending via a fixed income product. The difference of course is that the tenor of the lending is extended.

Within the total fixed income universe, floating rate note (FRN) products best replicate ‘cash’ product profiling because they reset the interest rate periodically and at fixed margins over known ‘cash like’ benchmarks.

However, the universe of global FRNs is significant, so the list would need to be diluted according to liquidity and yield relevance.

Key attributes that define both liquidity and yield within the banking sector include:

  • Capital structure seniority
  • Maturity
  • Credit quality
  • Issuance volume

Yield is usually inversely correlated with the credit rating and liquidity.  So, assets that rank lower in the capital structure, that are issued by weaker ranked or more volatile industries and have longer maturity dates, will, all other things being equal, likely have weaker credit ratings, and will subsequently be less liquid but deliver higher yield.

Australia’s major banks’ senior ranked, short to medium term FRN’s are the logical next step for higher yields over cash and term deposit products because they:

  • Are very low risk as evidenced by high investment grade ratings
  • Replicate rolling term deposit maturity and cash flow profiles
  • Offer extremely high liquidity
  • Deliver yields that exceed those of cash and term deposits

Q. How large is the bank senior FRN market? What returns are available?

Globally, senior bank bonds hold a dominant share of the entire bond or fixed income market. In Australia, major banks alone issue billions annually, with singular issuance lines in excess of $500m common.

Australian bank senior and subordinated bond issuance

Source: Bloomberg
AUD issuance only; total issued

To achieve better returns than term deposits, terms for Australian bank FRNs need to be greater than a year as shown in Table 2.

Credit margins for Australian bank investments

Table 2
Source: FIIG Securities
Margins accurate as at April 2017 but subject to change. 

These credit margins translate into the fixed rate returns* shown in Table 3. ​Conversion to fixed rates is required for comparative purposes, as term deposits are issued in fixed rates. The shaded area shows the opportunity for outperformance. *FRN’s pay a credit margin over bank bills, for a defined term. Those bank bill returns can be fixed by a contract of exchange, via the interest rate swap market.

Yields for senior bank investments 

Table 3
Source: FIIG Securities
Credit margins accurate as at April 2017 but subject to change

After one year, the book value entry yield of FRNs exceeds TDs. However it must be noted that for periods of less than one year, even though FRNs yield less, they are still liquid, and therefore liquidity (over TDs) is improved markedly, but at a cost.

Yield to maturity for Australian bank TDs and FRNs

Graph 1
Source: FIIG Securities.
Data accurate as at April 2017 but subject to change 

Q. Why do credit curves appear to be quite steep? Why would banks issue debt at higher yields at an increased cost? Is it genuinely a measure of credit risk or are there other contributing factors?

The gradient or steepness of credit curves is a product of the collective market assessment of both credit risk and the supply and demand for term money.  

Australian banks need term funding. Effectively they wish to reduce their balance sheet risk by borrowing for the same term (to maturity) for which they on-lend. A basic tenant of risk mitigation is to match assets and liabilities.

Think of a bank as an example, only lending money to home owners in variable interest rate form, and each home owner having a loan for five years before renegotiating. By issuing a five year FRN at a 1.00% credit margin, but on lending at a 2.00% credit margin to the home borrower, they have the asset (loan) matched to the liability (borrowing) and a profit of 1.00%.

Banks raise those funds from investors that require term investments, such as superannuation funds.  

Those funds have limits which dictate the volume of capital that can be lent to any one category of risk.

Superannuation funds lend billions into each maturity range or ‘bucket’, but they do have limits, and at each extension of term risk, they charge a premium. Where demand (superannuation capital to invest) meets supply (bank supplied debt) a price is determined. That price is the credit margin.

Superannuation funds have capital lending limits linked to their liquidity requirements, which are driven by their requirement to satisfy investor demand to be able to switch asset classes.

Specifically, the ‘zero to one year maturity’ band is perceived and is actually the most liquid band of all maturity categories (or bands), simply because it is the shortest and therefore has the least risk.

The steepness of credit curves is not singularly attributable to a measurement of credit worthiness, but of creditworthiness given demand and supply constraints. If there is excess supply delivered at a point of maturity that is not met by demand, the credit margin will move out to that point at which it attracts sufficient demand.

Q. The yield ‘uplift’ is between 0.50% and 1.00% depending on the bank issuer category, and the term to maturity. But the MIPS programs posted total returns in 2016 of more than 2.00% above the bank bill index. How did the MIPS team achieve this fantastic result?

A simplified answer is that credit margins and therefore yields were higher a year ago. That is part of the excess performance, and knowing when to invest in which assets at which credit margins is part of the skill set.

A good dealing team will know where to access the assets required at the lowest possible price, at any one point in time. They can be patient, placing bids and waiting for sellers to meet that price when they perceive there is minimal reason to rush, and they can alternatively be aggressive, paying what may be perceived to be a higher price, because they are ‘bullish’ and concerned that prices may increase quickly. A good dealing team, which we have in MIPS, adds significant value.

The detail of the opportunity to achieve better returns over cash, cannot be shown in a chart or table listing the book value entry yields. This is where portfolio management becomes more interesting, and it relies on a specific skill set to identify, analyse and deal on investment opportunities relentlessly and diligently.

The lion’s share of outperformance is derived singularly and in combination of applying the three investment methodologies:

  1. Riding the credit curve.
  2. Riding the credit curve differential offered by a step down in capital structure.
  3. Riding the forward credit curve of components both 1 & 2.

The timing of entry of use of each of those investment strategies, either singularly or collectively, depends upon both  current opportunities and future predictions of credit margins, and of the more important and dominant demand and supply factors that drive credit margins generally.

Q. This may be the point when the eyes glaze over for those with less technical knowledge. Could you please explain each investment methodology?

Each of these methodologies is employed by global investment managers, some more successfully than others, so we are talking about walking down a well-worn path. There is nothing elusive about this strategy. The skill set that determines its success is accurate forecasting of credit spreads and executing the deal.

1. Riding the credit curve

For example, if we use the data in Table 2, Investor 1 earns a higher yield by lending to a bank for a longer term than a shorter term by Investor 2. By lending for a longer term, the investor is paid a higher credit margin. So that Investor 1 who chooses to lend to a major bank by investing in senior FRNs for a five year term, will earn an additional 20 basis points (0.20%) per annum over Investor 2 who chooses to lend for a three year term.

However, the trade isn’t without risk, as the market value of the asset is determined by its secondary market credit margin. Where the margin goes higher, the asset devalues. This risk is however, mitigated by the ‘pull to par’, as the asset approaches maturity. Simply put, where an investor believes that credit margins will be stable, and there is no liquidity difference between each investment option, then ‘riding the credit curve’ is a sound strategy.

Q. Please explain what ‘pull to par’ means and how it mitigates risk?

As an asset approaches maturity, the cash flow that is generated by the product structure is more certain, and the exposure to business risk associated with the bank reduces. For example, in the last coupon period, the final cash flows are known. Because there is less time for anything to go wrong the credit margin contracts. At the extreme, one day from maturity, the credit margin will be minor as - at this point in time - the lending period is overnight. In effect, it has ‘pulled’ toward its maturing or ‘par’ value.

This is why the shape of the ‘credit’ curve is positive and why credit margins are lower for shorter maturities than they are for longer maturities. Looking at Table 2 you can observe the ‘pull to par’ occurring by comparing the credit margins.

2. Riding the credit curve differential by taking a step down the capital structure

As an extension of riding the yield curve, investors can also ride the capital structure curve. Because senior debt ranks higher for repayment than subordinated debt, it will yield less. That yield differential will be wider not only between steps in the capital structure but also in the term to maturity.

See Tables 4 and 5 showcase current credit margin differentials.

Credit margin for bank senior and subordinate bonds

Table 4
Source: FIIG Securities Note: Margins accurate as April 2017 but subject to change

An efficient market will price steps in the capital structure and maturity and issuer category with progressive increments in yield, reflecting risk and liquidity progression.

Subsequently, investors have the opportunity to extract more yield by riding a step down in the capital structure, and as an extension, a step down in credit quality of the bank issuer. Although both investment grade quality, a step into Minor bank subordinate debt from Major bank senior debt for example will deliver a book value entry yield advantage of 1.50% in the five year maturity term.

Those credit margin differentials result in yield differentials, as noted in Table 5.

Yield for bank senior and subordinate bonds 

Table 5
Source: FIIG Securities
Note: Margins accurate as at April 2017 but subject to change

Like riding the credit curve, this approach isn’t without risk for the same reasons. And again risk is mitigated by the ‘pull to par’ influence, as assets approach maturity.

3. Riding the forward credit curve

For example, using Table 1 again, Investor 3 earns a higher yield than Investor 1 from the prior example, by not just riding the credit curve, but by also selling that position prior to maturity and rolling the exposure back up the yield curve.

Again, referring to Table 1, an investor that buys a five year asset at a credit margin of 100 basis points, and sells the same asset in two years’ time (when the asset has three years to maturity) at a credit margin of 80 basis points (being the current credit margin, and in this example the expected margin in two years for an asset that has three remaining years to maturity) will make a 20 basis point capital gain. The investor can then re-lend that capital at a 100 point credit margin by investing in an asset that matures in five years again.

By repeating this method the investor constantly maintains a return of 100 basis points in credit margin plus a 10 basis point capital gain per annum (on an average four year remaining term) thus lifting their returns.

That 10 basis point per annum capital gain is significant. The investor receives upfront, the equivalent net present value of 10 basis points for each year outstanding (an average of four years).

That performance advantage is equivalent, in this example, to 29 basis points per annum. Appendix 1 maps out the numeric cash flow alternatives between buying and holding to maturity, or alternatively selling prior to maturity.

This strategy can be applied to any asset group, be it senior or subordinate debt. The steeper the yield curve and credit margins, the greater the opportunity for portfolio outperformance.

The strategy has risk for the same reasons listed above. The future credit margin at which the asset can be sold will be a direct function of current traded credit margins, known as the ‘spot’ price. If the issuer of the FRN experienced a period of financial stress, that credit margin would widen, and the price would fall.

If the ‘spot’ price falls, the ‘forward’ price will also fall – and the forward credit margins would widen. However, again that risk is also mitigated by the ‘pull to par’ as the asset approaches maturity.

Q. Can we presume that credit margins always behave like this? Can you give some historical perspective?

No, we cannot presume that credit margins will always behave like this, but they certainly have in recent years.  And the reason is explained below. But first let us look at the numbers.

Refer to both Graph 2 and Table 6. For the period from April to June 2016, the example asset credit margins were volatile, before tracking lower.

Major bank credit margin performance for the year ending April 2017

Graph 2
Source: Bloomberg

Graph 2 compares the CBA margins for senior and subordinate debt. Both assets had around 3.5 years to maturity in April 2016, then fell over a year to have a 2.5 year maturity profile, each ending the period with actual or near credit margin lows.

These example assets were chosen because they best reflect the weighted average tenor (maturity) and average exposure held within our most popular customised bank bond FRN portfolio. (Table 3 – Major Bank Senior & Subordinate) at the commencement and completion of the analysis.

At commencement of 1 April 2016, our customised major bank senior and subordinate portfolio had an average tenor of 3.21 years. One year later, being 31 March 2017, the same portfolio had an average tenor of 2.96 years.

Example major bank credit margin performance 

Table 6
Source: Bloomberg

Attribution of the return between ‘pull to par’ and credit margin contraction:

The change in credit margin can be attributed correctly, because at the start of the 12 month period we knew what the credit margins of major bank senior and subordinate securities of 2.5 year maturity were valued at at that time. They were +0.79% for senior and +1.78% for the subordinate.

The senior debt rallied .30% from a commencing credit margin of .96%, but given the same issuer’s 2.5 year maturity asset was trading at .79% a year ago, but is now trading at .66%, we can attribute .17% of the .30% rally in the credit margin to a ‘pull to par’, and the remaining .13% to a credit margin rally.

For the subordinate issue, we attribute .44% of the .85% rally in the credit margin to a ‘pull-to-par’, and the remaining .41% to a credit margin rally. See to Appendix 2.

The performance advantage of this move is 0.44% and 1.22% per annum for the senior and subordinate issues respectively.

Q. How does the rally impact portfolio returns?

Clearly the subordinate debt product credit margin rallied harder than the senior debt. The portfolio performance over the period will subsequently be impacted by the average allocation between the two alternate capital structure categories and the average tenor of each asset within those categories.

Setting aside cash holdings which fluctuate between 1.00% and 5.00% while waiting for price and trade execution opportunities, the MIPS Portfolio Management Team’s allocation by capital structure category average, was as documented in Table 7. 

Allocation and return by capital structure for year end 31/3/2017

Table 7
Source: FIIG Securities
Note: BV = Book value, MV = Market Value and CM = Credit Margin 

Q. Why did credit margins rally so much?

During the year, the Australian Prudential Regulatory Authority (APRA) increased regulatory requirements for the banks to hold additional capital, improving bank credit worthiness. APRA’s moves benefited bond issues sitting high in the capital structure, as it compelled the banks to raise capital lower in the capital structure.

Q. Other than APRA’s influence, can you explain how you forecast credit margins, and conclude with what your current forecasts are?

There are a significant number of contributing factors, including but not limited to macro-economic cycles, yields available for competing assets, credit performance and forecast credit performance of those competing assets, supply and intended supply into any one asset category, and many others.

Understanding what drives the credit margins at any one point in time is crucial in the forecasting process. In the last year, APRA’s influence was the main contributor. In the coming year I think that the opportunity for capital gains is limited. APRA’s influence has been priced in. I suggest the current focus is on macro economic factors.

If the Australian federal government achieves its current economic growth forecast, within its own fiscal budget expenditure parameters, which I believe it will, and banks maintain their lending standards and achieve target growth, which I believe they will, then I believe bank credit margins will remain stable.

Investors can subsequently expect a pull to par of approximately 0.20% per calendar year and some opportunity for capital gain via the MIPS Portfolio Management Team accessing optimal pricing and execution. For senior bank and subordinate bank FRN exposure, that will translate to an additional contribution to performance of approximately 0.20% and 0.60% per annum respectively. Subsequently we expect additional performance within the bank bond FRN programs of approximately 0.40% from active management.

Appendix 1

Assume two paths:

Path A: The investor (Investor 1) retains the asset originally bought at a 1.00% credit margin, choosing to hold to maturity.

Path B: The investor (Investor 3) sells the asset originally bought ($9.078m) at a credit margin of 1.00%, for a credit margin of 0.80% 2 years after purchase, when it has three years left to mature.

Investor 3 crystallises a 0.29% capital gain and reinvests that capital and final coupon ($9.535m) into a five year asset, again at +1.00% credit margin.

Appendix 1 – Hold to maturity or hold for two years and sell

Source: FIIG Securities

Appendix 2 – Performance of CBA senior and subordinate FRN’s for the year ending 31 March 2017

Source: FIIG Securities

kieran quaine

Kieran Quaine
Head of MIPS

Kieran Quaine is the Head of the Managed Income Portfolio Service and is responsible for all investment decisions. He has over 30 years’ experience in the fixed income markets.

Kieran has been at FIIG for over eight years, most recently holding the dual roles of Head of Syndication and Head of Market Risk, which included responsibility for primary bond sales for all FIIG originations, exceeding $1bn, balance sheet management and security pricing for all debt products.

Prior to joining FIIG, Kieran was the joint founding partner of a mortgage origination company, a Senior Fixed Income Portfolio Manager for one of Australia’s largest Superannuation Fund Managers, and a Proprietary Interest Rate Trader for a large US Investment Bank.

Kieran has a Bachelor of Accounting from Canberra University, holds a Diploma of Financial Services (financial markets), and is a former chairman of the AFMA Debt Capital Markets Committee.


Credit margin

The price or margin that investors require over and above the benchmark BBSW rate.

Basis points

The basis point is commonly used for calculating changes in interest rates, equity indices and the yield of a fixed income security. The relationship between percentage changes and basis points can be summarised as follows:

Duration or Modified Duration

Modified duration is a measure of a portfolio’s sensitivity to movements in interest rates. Modified duration is the percentage change in a bond's price for a 1.00 percent change in whole yield curve. For example, a portfolio with a three year duration would lose 3% if that interest rate curve moved up by 1% across the whole curve. Conversely, a 1% downward move across the curve would result in a 3% gain.

Floating rate bonds (FRNs)

Floating rate notes are bonds that have a variable coupon, equal to a reference market base rate, like 90 day bank bill swap rate (BBSW), plus a margin. The majority of FRNs have quarterly coupons, that is pay interest every three months.


Bonds that are classified as High Quality Liquid Assets (HQLA) by the RBA. The RBA provides liquidity for these bonds in all market conditions. Senior bank FRNs qualify as HQLA.