Tuesday 03 May 2016 by FIIG Securities FIIG Securities Opinion

Cash rate cut + negative inflation = fixed rate bonds

Yesterday’s cash rate cut and the possibility of further cuts mean it makes sense to lock in fixed rate returns now.  Our view remains interest rates will be lower for longer. Just how low and how long remains to be seen. This note covers interest rates, inflation and makes some fixed rate bond suggestions

base jumper

1. Interest rates

Yesterday the Reserve Bank Board cut the cash rate for the first time in a year with the surprise negative quarterly inflation figure last week contributing to the cut.

"Inflation has been quite low for some time and recent data were unexpectedly low. While the quarterly data contains some temporary factors, these results, together with ongoing very subdued growth in labour costs and very low cost pressures elsewhere in the world, point to a lower outlook for inflation than previously forecast…the Board judged that prospects for sustainable growth in the economy, with inflation returning to target over time, would be improved by easing monetary policy”

Barely two weeks ago, on 20 April 2016, and prior to the quarterly inflation release, economists had priced in a potential cash rate cut of just 16% for May. After the –0.2% inflation result the percentage then jumped to 53%. Many professionals are just as skittish as the investors on the street.

Our stance has not changed. Chief Economist, Craig Swanger has held firm that there would be additional cash rate cuts this year. He believes it is important to consider fundamentals and not get swept up in the tide of sentiment, ultimately being proven to be correct with the new low 1.75% rate.

Below is the ASX 30 Day Interbank Cash Rate graph as at 3 May, prior to the cash rate announcement. It shows the implied forward changes to the official cash rate for the next 18 months. You can see the rate deteriorates to a low point in May 2017 when it hits 1.615%. Even before the cash rate announcement, sentiment was weighted towards a second interest rate cut in the coming year.

It’ll be interesting to see the graph today – if you are interested the link is ASX 30 Day Interbank Cash Rate.External link - opens in a new window

2. Inflation

Two notes regarding inflation were uploaded to http://thewire.fiig.com.au/External link - opens in a new window during the last week.

Australian inflation and implications for interest ratesExternal link - opens in a new window
28 April by Craig Swanger

The risks to the Australian economy are rising…the longer term outlook for the global economy and the ability of the Australian economy to withstand further global, and particularly Chinese, declines, means that the risks to interest rates in Australia remains on the downside. And of course, lower Australian interest rates during a time when the US and UK interest rates are erring to the upside, means higher risks to the downside for the Australian dollar.

Sydney Airport bonds a high flying investment opportunity in a low rate worldExternal link - opens in a new window
Published in The Australian on 3 May by Elizabeth Moran

Over the last week, two separate events have highlighted the attractiveness of Sydney Airports’ domestic bonds – a new USD issue equivalent to AUD1.2 billion with a fixed return and low inflation.

3. Fixed rate bonds

Volatility and risks to the downside imply investors should consider a high allocation to fixed rate bonds which provide absolute certainty. If you need a minimum cashflow from your investments, floating rate instruments may not necessarily deliver. The ANZ bank result should also sound warning bells to investors reliant on dividends for income.

Below are two tables, the first with some long dated investment grade fixed rate bonds. For some time I’ve liked the Rabobank senior bond with a running yield or income approaching 5% per annum and a yield to maturity (April 2024) of 3.87%pa. For those that don’t want to go that long, the shorter-dated (May 2017)Swiss Re hybrid, that we believe will be called next year, offers an appealing yield to worst of 4.82%.

The second shows four high yield options that offer very attractive returns but also higher risk given they are issued by smaller companies and are smaller dollar value issues. You are being paid for that additional risk including possible illiquidity given a smaller market. If you are looking for hold to maturity investments and higher returns these bonds may suit you. I’ve been a fan of the CBL bond for some time. It’s rated investment grade by specialist credit rating insurer, A.M. Best.

It’s not too late to reassess the interest rate protection in your portfolio. You would set up your portfolio to support your view of how low you think interest rates might go and for how long.

For those with a very negative view, I’d suggest locking in more long dated protection as soon as possible. 

Investment grade fixed rate bonds

Company Call/maturity date Capital structure Trading margin Yield to call/maturity Income/running yield Capital price
Queensland Treasury Corporation 14/03/2033 Senior Debt 0.39% 3.29% 4.60% 141.202
Rabobank Netherlands AU 11/04/2024 Senior Debt 1.25% 3.81% 4.93% 111.498
Asciano Finance Ltd 19/05/2025 Senior Debt 2.25% 4.87% 5.11% 102.764
Elm Bv (Swiss Rein Co)* 25/05/2017* Hybrid Tier 1 2.60% 4.66% 7.41% 103.025

Note: Prices accurate as at 3 May 2016
Minimum parcel sizes vary
Black = all investors, red = wholesale only
*This is a call date

High yield fixed rate bonds

Company Call / maturity date Capital structure Trading margin Yield to call/maturity Income/running yield Capital price
Sunland Capital Pty Ltd 25/11/2020 Senior Debt 5.12% 7.47% 7.53% 100.300
SCT Logistics 24/06/2021 Senior Debt 4.66% 7.04% 7.46% 102.600
G8 Education Limited 07/08/2019 Senior Debt 4.49% 6.64% 7.43% 102.900
CBL Corporation Limited 17/04/2019 Senior Debt 4.02% 6.11% 7.81% 105.700

Note: Prices accurate as at 3 May 2016
Minimum parcel sizes vary
Black = all investors, red = wholesale only