Tuesday 19 August 2014 by FIIG Research Legacy

From the Trading Desk (19/08/14)

Yield direction and volatility

US retail sales figures and jobless claims kept yields low last week, as both came in weaker than market expectations. Retail sales slowed for the month of July with little change, whereas the market was expecting a 0.2% increase. This spurred speculation the Federal Reserve will keep interest rates unchanged for longer. The four week average jobless claims increased to 311,000 in the period ended 9 August, where 295,000 was the forecast for the period.      

In reaction to the news the Australian 5 year and 10 year benchmark swap rates closed 6-9 basis points (bps) lower over the week, finishing at 3.19% and 3.74% respectively. The 5 year and 10 year Commonwealth Government yields were down 1bp each for the week, closing at 2.84% and 3.39%.

The focus domestically this week will be RBA Governor Glenn Stevens’ semi-annual testimony to parliament. In the US the Federal Open Market Committee is conducting its monthly meeting.

Relative value note - Inflation linked bonds over short dated floating rate notes

Over the past several weeks it has become clear that the Australian economic outlook is cloudy, with the dichotomy in the latest readings of inflation and employment and recent statements from the Reserve Bank. The RBA is caught between a rock and a hard place, with inflation and unemployment both trending higher. They have clearly indicated that, at least in the short term, unemployment is the greater concern and they seem to think inflation will reverse direction. Many among us disagree, although the RBA surely have their reasons. But the direction is clear: lower rates for longer. And the risk is that this stokes inflation further, which is already running at 3.0% and following a rising trend.

Furthermore, maintaining interest rates lower for longer implies the yield curve should flatten further (i.e. longer term rates should come down). While this has been occurring over the past year, the curve is still relatively steep by historical standards and there is significant room for longer term rates to fall further.

It is the view of this contributor that investors should consider switching out of short-dated floating rate notes (and for that matter, low yielding fixed rate bonds) in favour of inflation linked products, or simply add inflation linked products to their portfolios. The combination of rising inflation and the continued flattening of the yield curve will benefit this strategy. If the view proves flawed, inflation linked products will still benefit from one or the other of these two opposing forces (falling interest rates or rising inflation). Furthermore, a product earning CPI+3% is currently returning 6%.

Contact your FIIG representative to discuss options to incorporate this strategy into your portfolio.

Other credit margins and trading activity

The continued supply of index annuity bonds (IABs) ensured much activity among inflation linked assets last week. Three of FIIG’s most favoured IABs, Wyuna March 2022, Plenary Justice June 2030 and Civic Nexus September 2032, became available via an institutional market offer. Stock was quickly spoken for as investors came back to the market after a shortage in IAB supply in recent weeks. While offers of the Wyuna and Plenary Justice have since dried up, Civic Nexus and the MPC December 2033 IABs remain in reasonable supply. Current indicative offers are below:

  • Civic Nexus Sept 2032: 5.40%
  • MPC Funding Dec 2033: 5.44%

In the capital index bond (CIB) space there was little change as the Sydney Airport 2020 streaked ahead to again become FIIG’s most traded security for the week by a fair margin. The Sydney Airport 2030 issue was also in good supply as some holders chose to lower duration and switch exposure to the shorter dated 2020 bond. Both securities are currently in excellent supply. Indicative offer levels are below:

  • Sydney Airport Nov 2020: 5.65%
  • Sydney Airport Nov 2030: 6.28%

The Bendigo and Adelaide January 2019 Lower Tier 2 (LT2) floating rate note (FRN) traded heavily last week following the announcement of a new LT2 offer to be issued by ME Bank later this week. The announcement saw some price softness in the ‘new style’ LT2 market as the institutional market anticipated the new issue. Some clients took the opportunity to reduce their positions in the Bendigo and Adelaide issue as the issue looks to be fully priced at current levels. FIIG is well positioned to execute client sale orders at an indicative trading margin of +228 to swap.

G8 Education Limited’s Aug 2019 fixed coupon bond enjoyed a second week of active trading since becoming available to retail investors. Demand is still very strong as the G8’s make up only a handful of FIIG corporate issues eligible for retail investors. FIIG is very well placed to execute client sale orders at an indicative yield to maturity of 6.45%.


Market levels are indicative as at 18 August 2014 and subject to change based on demand and market movements.

Yields for floating rate notes are estimated as the sum of the swap rate to maturity / call and the trading margin.

Yields for capital indexed bonds and index annuity bonds are estimated as the real yield plus a 2.50% inflation assumption.

Key terms

Basis points (bps)

The basis point is commonly used for calculating changes in interest rates, equity indices and the yield of a fixed income security. The relationship between percentage changes and basis points can be summarised as follows:

Bank bill swap rate (BBSW)

A compilation and average of market rates supplied by domestic banks in regard to the specific maturities of bank bills. BBSW is calculated at ten o’clock every morning and compiled by AFMA.

The purpose of BBSW is to provide independent and transparent reference rates for the pricing and revaluation of Australian dollar derivatives and securities.

Call date

The date prior to maturity on which a callable bond may be redeemed by the issuer. If the issuer determines there is a benefit to refinancing the issue, the bond may be redeemed on the call date, at par, or at a small premium to par depending on the terms of the call option.