Monday 08 October 2018 by FIIG Securities skinnymargins Opinion

Skinny margins making it less painful to reduce risk

Are we there yet – have we reached the top of the investment cycle? It’s the question on everyone’s lips as all assets look expensive. I think we’re near the point investors should be starting to think about capital preservation rather than yield. Skinny margins between asset classes make it an easier decision to switch out of growth assets and into defensive ones. 

Disregard the signals at your own peril. Ten years on from the GFC and some of us may not have the five or ten years it would take to recover from another major asset dislocation.

Let’s look at expectations of future interest rates and the margins or spread above benchmarks to get a feeling for returns on offer given various levels of risk. 

# Last 12 months gross yield, assume same rate going forward. 
Source: Bloomberg, FIIG, RBA

What the table shows is that investors are still getting paid for investing in higher risk asset classes, but there’s also an opportunity at the moment to take risk off the table in preparation for the next downturn without taking a big hit to income.

I’ll often hear investors say they would be happy with a 5 or 6 per cent per annum return. But will Australian rates follow the US rates higher?

Fortunately there are a few securities that ‘provide a window to interest rate expectations’ and also help investors assess relative value between various asset classes.

Two common benchmarks, the Bank Bill Swap Rate (BBSW) and the Commonwealth government bond rates help us understand the market’s future interest rate expectations. BBSW is commonly used in pricing floating rate investments and simply is where banks are indifferent between fixed and floating rate interest rates. As of 26 September, 90 day BBSW was 1.94 per cent increasing to 1.99 per cent over one year, 2.51 per cent for five years and 2.87 per cent over ten years. Putting in BBSW at future time intervals allows us to plot the rates on a graph, creating a yield curve – a map of future interest rate expectations.

Commonwealth government bond rates are fairly benign just like BBSW. The one year rate is close to BBSW at 1.93 per cent but the gap widens at five years by 0.26 per cent then narrows over ten years to 0.17 per cent with the yield a low 2.87 per cent.

Very small increases over time to BBSW and government bonds, tell me not to expect interest rate rises for some time nor expect to get paid for investing for longer. This is why we are suggesting investors add floating rate investments at the moment. Any expectation of higher interest rates will feed through into higher income payments. However, some investors may be of the view that any additional increase in yield is worth taking the risk of investing in fixed rate investments for longer.

While the benchmark rates tell us to expect low interest rates, other higher risk investments should pay a yield over the benchmarks – the greater the spread above the benchmark, the greater the perceived risk.

Term deposits pay a small margin over BBSW. According to Australia Bank Term Deposit Interest Rates sourced from the RBA and our in-house term deposit rates, there’s little additional margin over BBSW over terms out to five years. There are specials that will offer higher term deposit rates than what’s shown, but this is useful to get a feeling for what may be a good rate compared to other asset classes.  Few investors would chose to invest in fixed rate term deposits for longer than three years in such a low rate interest environment.

Moving out along the risk spectrum and investing in still low, but higher risk, BBB rated investment grade corporate bonds, sees higher margins and overall yields. They don’t look like much, but compound over time.

While we cannot predict future gross dividend yields, I’ve included the average for the last 12 months as a guide. The yield is higher than BBB rated corporate bonds as you would expect but the differential is small. Where you have relative certainty over capital repayment with the bonds, it is unknown in the shares.

Asset allocation is all about getting the balance between defensive and growth assets right. In the search for yield investors have taken on more risk, perhaps overly exposing them to the next correction.