Tuesday 21 March 2017 by FIIG Securities boats Trade opportunities

Floating rate bonds in focus as Fed hikes rates

As published in the Australian 21 March 2017

If you believe interest rates will rise, floating rate investments may provide better returns than their fixed rate counterparts

The US Federal Reserve has finally increased interest rates from a range of 0.5 to 0.75 percent to 0.75 to 1.0 percent. It’s a long awaited and relatively significant increase, but looking back to early 2016 it’s taken a lot longer for the Fed to move than most market pundits expected.

Will they or won’t they raise rates again this year?

The last move in December 2016 was only the second time rates had been increased in the last decade and the only increase last year, when consensus and the Fed predicted four rate rises. The Fed has been quick to signal but slow to move, cautious of stymieing growth and employment.

However, after the Fed released its new economic projections, it still only expects to hike twice more this year.  The market is pricing in two more with a 20 percent chance of a third additional hike. Economic data may support further increases but think of the tortoise not the hare.

How does this translate into interest rate moves in the domestic market and how do you position your portfolio for the changes?

Rising US Treasury rates will impact mortgage rates here as all the major banks borrow funds offshore and have already been taking the opportunity to raise lending rates. So, even though the RBA has not increased rates and is unlikely to, borrowers will start to see costs rise.

Our clients have favoured fixed rate bonds for many years. They like the certainty of the returns, especially those in drawdown, seeking known income. The market has been very conducive towards fixed rate bonds, as interest rates have been declining, prices have risen, but expectations are changing.

If this is the low point or close to it, in the domestic interest rate cycle, investors should be starting to add floating rate instruments, so that the investments take advantage of the environment and avoid the costs of rolling short term fixed rate investments.

New products for a changing climate

Floating rate investments such as deposits, corporate bonds and hybrids are linked to the benchmark bank bill swap rate (BBSW) indices, and interest paid will rise as interest rate expectations rise – all boats rise on an incoming tide. But the opposite is also true, lower rates would reduce income, making these investments less certain than their fixed rate counterparts.

Unknown to most investors, some banks offer floating rate term deposits. ING offers floating rates for terms over a year. Generally, the rates they offer are lower than fixed rates for equivalent terms, so don’t seem as attractive. But fixed rate deposits pay annual interest while floating rate deposits pay quarterly.

If you believe interest rates will rise, overall floating rate returns may provide better returns over the term of the deposit. At the moment, ING offers higher margins over BBSW for longer terms. The margin starts at 0.5 percent for one year and increases to 1.2 percent over five years.

ING fixed and floating term deposit rates

Term Fixed (annual interest) Floating rate (paid quarterly)
First rate set Margin
One year 2.61% 2.30% 0.50%
Two years 2.74% 2.55% 0.75%
Three years 3.04% 2.80% 1.00%
Four years 3.32% 2.90% 1.10%
Five years 3.57% 3.00% 1.20%
Source: ING Bank
Note: All percentages are per annum
Interest rates are indicative only and subject to change. The rates set out above are for balances up to $5m.

There are also a number of floating rate corporate bonds available in the over-the-counter market. Interest is calculated quarterly and paid in arrears. Margins over BBSW range from 1.44 percent for an ANZ subordinated bond with an overall yield to maturity of 3.99 percent to a margin of 3.76 percent – for ASX listed wholesale distributor of computer hardware and related products, Dicker Data senior bond, with a yield to maturity of 5.65 percent.

Company Maturity/call date Trading margin over BBSW Yield to worst*
ANZ 17/05/2021 1.44% 3.99%
Dalrymple Bay Coal Terminal 09/06/2021 2.33% 4.88%
Dicker Data 26/03/2020 3.46% 5.65%
Members Equity Bank 29/08/2019 1.65% 3.73%
Suncorp subsidiary, AAI 06/10/2022 1.87% 4.58%
Source: FIIG Securities
Note: Rates accurate as at 16 March 2017 but subject to change
Minimum investment in OTC bonds is $10,000 per bond, $50,000 up front
*Yield to worst is the worst yield an investor can expect if they hold a callable bond

ASX listed floating rate hybrids are another option and margins are slightly higher to compensate for higher risk.

We have generally been suggesting to our clients that they reweight their portfolios and reduce exposure to longer term fixed interest rates, by moving out of long dated fixed rate bonds and into shorter dated bonds and by adding floating rate bonds.

While many commentators deride bonds, they usually only refer to fixed rate government bonds. It might be a poor time to invest in the lowest risk fixed rate bonds, especially if we are in for an extended period of higher interest rates. But, yields today already factor in higher expectations. If the expectations don’t materialise, longer dated fixed rate bonds may prove to be cheap.