Tuesday 26 June 2018 by FIIG Securities longvshort Trade opportunities

Reduce risk in your portfolio Part 4 – Short over long

The final note in the ‘Reduce risk’ series compares shorter dated AUD and USD bonds against the yields on offer for longer dated bonds issued by the same company. We provide suggestions for each currency

There has been a lot of commentary about rising interest rates and we’ve certainly seen rates rise in the US, with the Fed announcing another increase to 1.75% to 2% just last week.

Fed interest rate rises have worked to increase short term rates but longer term rates have barely shifted and there’s been some talk of an inverted yield curve – where short term interest rates are higher than longer term rates. Historically, an inverted yield curve has often been the precursor to a recession, understandably worrying some investors and commentators.

Source: Bloomberg, FIIG Securities
Figure 1

Domestically, the RBA came out last week and dropped a long standing comment in its Minutes that the next move would more likely be up. Since then we’ve witnessed a slew of economists come out and restate expected timeframes for the next RBA cash rate move. One I read is now predicting it could be 2020 before the RBA moves.

No matter what the RBA does, it is probably more important for bond investors to follow the bank bill swap rate (BBSW). As previously discussed in the note ‘Interest rates are moving even though the cash rate isn’t’, BBSW has been moving up.

Changing BBSW has seen some spread widening, especially shorter dated ones, making bond prices lower and yields higher. Not so good for existing holders, but making the bonds more attractive than they have been for a while for new investors.

Source: Bloomberg, FIIG Securities
Figure 2

Australian corporate bonds are priced off the BBSW curve. The research team has been concerned that higher global rates will translate to lower bond prices, especially for holders of longer dated fixed rate bonds, thus their preference for shorter dated bonds over longer dated bonds and short duration over long duration.

I am of the view that we don’t know how long low interest rates will last and I would still hold some longer dated fixed rate bonds to cover the possibility that interest rates may not move higher as widely expected.

Below is some sample short and longer dated bonds and the YTWs on offer.

AUD short versus long

Issuer Call date Maturity date Bond type Trading margin  Yield to maturity
DBCT Finance Pty Ltd (Dalrymple Bay)
9-Jun-21 Floating 1.99% 4.17%pa
DBCT Finance Pty Ltd (Dalrymple Bay)
9-Jun-26 Floating 3.28% 5.98%pa
General Property Trust 11-Sep-20 Fixed 1.03% 3.16%pa
General Property Trust 24-Feb-26 24-Aug-26 Fixed 1.07% 3.77%pa
New South Wales Treasury Corporation   1-Jun-20 Fixed -0.27% 1.85%pa
New South Wales Treasury Corporation 
1-May-30 Fixed -0.20% 2.94%pa
Qantas Airways
27-Apr-20 Fixed 0.88% 2.99%pa
Qantas Airways   12-Oct-26 Fixed 1.08% 3.86%pa
Source: FIIG Securities
Note: Yields accurate as at 26 June 2018, but subject to change

If you look at the trading margin of the corporations, that is the margin relative to the benchmark BBSW rate, both the GPT and Qantas longer dated bonds offer a marginal pick up in credit spread for the additional risk – 4bps for GPT and 20bps for Qantas, the larger contributor to the overall yield being the benchmark BBSW.

Investors need to question whether the additional yield for around six years is worth the additional duration risk, where rising interest rates would force the price down and a potential loss to trading investors.

Dalrymple Bay Coal Terminal bonds which are floating rate show a better trading margin and overall differential.

USD short versus long

Issuer Credit rating Maturity date Trading margin Yield to maturity
Dell Inc. BB- 15-Apr-28 2.84% 5.78%pa
Dell Inc. BB- 15-Apr-38 3.47% 6.45%pa
Diamond Finance Corp BBB- 15-Jun-26 1.95% 4.87%pa
Diamond Finance Corp BBB- 15-Jul-36 3.22% 6.21%pa
Navient Corp B+ 25-Sep-23 2.87% 5.77%pa
Navient Corp B+ 1-Aug-33 4.04% 7.02%pa
Newcrest Finance Pty Ltd BBB- 15-Nov-21 1.07% 3.94%pa
Newcrest Finance Pty Ltd BBB- 15-Nov-41 2.39% 5.37%pa
TransAlta Corp BBB-
15-Nov-22 1.37% 4.32%pa
TransAlta Corp BBB-
15-Mar-40 3.45% 6.48%pa
Vodafone Group PLC BBB+ 26-Sep-22 0.29% 3.18%pa
Vodafone Group PLC BBB+
19-Feb-43 1.92% 4.90%pa
Source: FIIG Securities
Note: Yields accurate as at 26 June 2018, but subject to change
All bonds are fixed rate and available to wholesale investors only

At first glance, the differentials in the USD space look better than in AUD, but the time between maturity dates is much longer, in the case of Newcrest 20 years. Simply, the 5.37%pa return looks attractive, especially if you want longer term fixed rate exposure but the Newcrest 41s are trading at a premium of USD105. The very long maturity date exposes the investor to significant interest rates risk, which is fine as long as it is understood. Sustained longer term interest rates could negatively impact the bond price.

Considering a ten year differential, and the BB- yield curve showing the average spread differential between two BB- rated bonds with 10 and 20 years until maturity is 82 basis points, the 63bps spread between the Dell bonds isn’t considered enough for the additional ten years until maturity.

Changing interest rates will impact bond prices, particularly fixed rate bonds. Investors that are ‘hold to maturity’ will see valuations change over time but the changes won’t impact actual returns.

For more information, please call your local relationship manager.