As interest rates move lower, investors are taking on more credit risk to
compensate for the drop in yield. While higher risk does offer higher
return, it is important to maintain adequate portfolio quality and
diversity. The Queensland Treasury Corporation (QTC) 6.50% 2033
bond offers a strong income stream while providing exposure to a
liquid and low risk government credit.
Background
Ongoing market uncertainty, trade wars and geopolitical tensions have culminated in slower domestic economic growth. This in turn has led to the lowest RBA cash rate in Australian history.
With traditional investments such as term deposits and annuities paying lower returns, investors are starting to look at riskier investment options to maintain an adequate income stream.
When investing in bonds, there are two components to consider – income (as measured by running yield) and capital stability. With its high coupon, the QTC 6.50% 2033 bond provides a high income stream with relatively low credit risk.
QTC 2033 maturity bond
As rates move lower, new bonds are issuing with lower coupon margins. For example, Pacific National (a low investment grade rated Australian corporate) recently issued a 10 year bond with a coupon of 3.70%, which translates into running yield of 3.50%, at the current price.
In comparison, the 6.50% coupon on the QTC 2033 bond looks attractive. Despite the fact that this bond’s price has rallied significantly (now trading above $160), the high coupon means that running yield on this bond is 4.04%. So investors will receive an annual income return from this bond of over 4% and yield to maturity of 1.5%. The low yield to maturity reflects the high capital price and therefore investors are notionally receiving a portion of their capital back with each coupon payment.
Given this bond has a high duration, the bond price will be driven in the near term by movement in interest rates (rather than the typical movement back toward par for bonds nearing their final repayment). With the current bearish interest rate outlook, we expect the capital price on this bond to remain broadly stable. Furthermore, the fact that this bond has a longer time to maturity gives us comfort in using running yield as a measure for income compared to shorter dated high coupon corporate bonds, which move towards par at a rapid rate as maturity approaches.
Additionally, unlike corporate bonds, the QTC 6.50% 2033 bond has low credit risk as it is backed by government exposure. QTC carries a strong investment grade rating and is Queensland’s central financing authority and corporate treasury services provider offering a range of financial services to the state and its public sector entities.
We believe this bond should be included in a diversified bond portfolio as it offers a relatively high income stream, low risk government exposure and high level of liquidity in secondary market trading.
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