Tuesday 01 October 2013 by FIIG Research Legacy

From the Trading Desk (01/10/13)


We are nearly two weeks into secondary trading of the new Cash Converters bond and this still looks like the stand-out opportunity for wholesale investors. With all three of our previous originated issues (Silver Chef, Mackay Sugar, and G8 Education) now offered at swap plus 345 bps or dearer, Cash Converters is notably cheap at swap plus 395 bps, or a yield of around 7.53%.

Another great opportunity we see at the moment, for wholesale and retail investors alike, is the Australian National University Indexed Annuity Bond maturing October 2029. This bond is currently trading at CPI plus 3.50% for a credit profile that is akin to that of the Australian Commonwealth government.

Getting the most out of your portfolio - The problem with hold-to-maturity

One of the advantages about investing in fixed income over other asset classes is the obligation of the issuer to repay the principal on a fixed maturity date, giving the investor the freedom to “set and forget” the investment. Hold-to-maturity is a sound strategy, especially when you consider the objective is to get a known return over a relatively long term.

However, as with any investment, the assets should be monitored on a regular basis. The primary purpose for this review is to monitor whether there are any changes to default risks implicit in the assets, but there are other reasons why hold-to-maturity should be reconsidered. The two most commonly overlooked reasons are: relative value in alternative investments and reinvestment options for assets approaching maturity.

Relative value

At any stage in the economic cycle, there are always assets that will outperform and assets that will underperform. For example, if inflation expectations, and therefore interest rates, are on the rise, investors should shy away from longer-term fixed rate bonds in favour of floating rate notes (at this stage of the economic cycle inflation-linked products have already factored in rising inflation), as the market value in the former will inevitably decrease and the market value in the latter will inevitably increase. The opposite is true in a decreasing inflation and interest rate environment.

The consideration is more than merely market value, though. By the nature of the asset, the absolute return on a floating rate note will decrease as rates fall and increase as rates rise, so portfolios should be rebalanced based on the investor’s view on interest rates over the short to medium term.

By way of example, we take the Vero Insurance floating rate note maturing 23 September 2014 and paying a coupon rate of 3-month BBSW plus 1%. If an investor purchased this bond in January 2011 at a capital price of $95, the coupon rate was 6.03%, so the investor would be receiving a rate (running yield) of 6.347% (6.03% / 0.95). Nearly three years later, the current coupon rate of that security is 3.5783% and the asset is now returning a running yield of 3.767% on the same investment. For investors who are dependent on that running yield for income, this possibly no longer provides that necessary income and the investor should seek an alternative investment.

Reinvestment risk

The other consideration that becomes increasingly important as assets approach maturity is reinvestment of those funds. In our view, investors should start considering those options from around a year from maturity of the asset. Because bonds have a level of liquidity not available in term deposits, an investor is not forced to wait until maturity to consider these options, and will be paid out any accrued interest due upon sale of the assets. Keeping in mind your interest rate expectations in the short term, it may be wise to look at current alternatives. For example, if you were of the view that interest rates may decline in the next year, waiting for maturity of a floating rate note may be detrimental to your overall return in the coming year. So, it is worthwhile to think about reinvestment options well before maturity. The opportunities for reinvestment that are available today will almost certainly be different than the options that will be available when the asset matures. That is not to say reinvestment must take place early, but it would make sense to consider the options.

What to look for in your portfolio

At the current stage in the cycle, interest rates are expected to creep lower and remain low over the next two to three years. As such, the yield curve out to six to eight years continues to appear too steep, offering opportunities for investment in that part of the curve.  Investors should be looking to switch into medium dated (six to eight years) fixed coupon bonds, from any holdings that meet one of two criteria, particularly where they have already performed strongly over the past year or two:

  • Short to medium dated floating rate notes, especially investment bank paper that has performed well and has little room to contract further in spread.
  • Fixed and floating rate bonds approaching maturity within one year

If any of the assets in your portfolio meet these criteria, it may be worthwhile to enquire about switch opportunities. Your FIIG representative will have a number of good candidates at hand.