Navigating bonds with rising interest rates

Orchestrated moves by central banks around the globe to cut interest rates to help stimulate economic growth have benefited bond investors, Russel Chesler writes.

Falling bond yields have delivered high capital gains, as well as reliable income, to bondholders. Yet most Australian investors have been missing out on this reliable income stream which bonds provide. Many Australian investors are instead holding too much cash, which is yielding very little, possibly 2 per cent or less per annum. 

Self‐managed superannuation funds (SMSFs), for example, hold almost one‐quarter of their portfolios in cash and term deposits. In contrast, they hold around 30 per cent of their assets in Australian equities and just 1.4 per cent in debt securities such as bonds. 

Yet bonds are a valuable source of additional reliable income for investors, with yields potentially higher than cash and some ‘income’ equities. On top of that, some types of bonds, called floating rate notes (FRNs), can be an effective enhancement to cash allocations as the coupon on these bonds will rise with official interest rates, unlike traditional fixed rate bonds.

 

What are floating rate notes? 

A FRN is a type of corporate bond that pays a variable interest rate. That contrasts with traditional fixed coupon bonds where the interest rate will never vary over the life of the bond. As interest rates rise, the value of bonds with fixed‐rate coupons goes down because demand for those bonds falls in favour of newer bonds being issued with higher coupons. 

On the other hand, the coupon on a FRN is ‘floating’, which means the interest rate is reset every quarter. Coupons typically track the 90‐day bank bill swap (BBSW) rate, which rises (and falls) with official interest rates. For example, a FRN may be issued with a face value of $100 for 3 years with a coupon of ‘3‐month BBSW + 1 per cent’. This means coupon payments will increase if the benchmark 3month BBSW rate rises, or decrease if the 3‐month BBSW rate falls. Importantly, a variable coupon has the effect of preserving the capital value of the bond in a rising interest rate environment as it will help to maintain demand for the bond from investors.

 

Defining duration

This brings us to a concept called duration.  Duration measures the sensitivity of a bond to changes in interest rate movements.  For example, if the measure of the interest rate sensitivity of a bond, or modified duration, is 4.00, that means that with a 1 per cent rate rise, the value of the bond would fall 4.00 per cent.  For bonds with fixed coupons, the longer the time to maturity, the higher the duration and therefore, the greater the sensitivity of the bond’s price to interest rate changes.

The modified duration on the Bloomberg AusBond Composite 0+ Yr Index, the benchmark index for government and corporate bonds with fixed coupons, is 4.95, meaning for a 1 per cent rise in interest rates, the bonds in the index could be expected to fall in value by 4.95 per cent.

In contrast, the modified duration on the FRN benchmark, the Bloomberg AusBond Credit FRN 0+ Yr Index, is currently around 0.12, which means for every 1 per cent rise in interest rates, the combined value of the FRNs in the index could be expected to fall by only 0.12 per cent.

The much lower duration on the FRN benchmark index highlights that FRNs are not very sensitive to changes in interest rates, therefore, their value/price is likely to be relatively unaffected when interest rates rise compared to traditional bonds with fixed coupons.

The other distinguishing feature of FRNs is that they generally pay income every quarter, compared to government bonds, for example, which pay income every six months. 

 

Example of how FRNs work

The example below indicates how income from a FRN is derived. FRNs are commonly issued by financial institutions in Australia, including the one described below.

  • The Commonwealth Bank issued a floating rate note on 12 July 2016 with a maturity date of 12 July 2021. 
  • The interest rate is set at 3‐month BBSW plus a fixed margin of 1.21 per cent. 
  • The bond was issued for five years and pays quarterly interest. 
  • On the very first day of issue, investors outlaid $100 per bond. The 3‐month BBSW rate is taken that day and added to the fixed margin of 1.21 per cent to determine the interest rate applicable for the coming quarter. 
  • The coupon rate for a quarter is calculated at the time the interest is paid for the previous quarter.  
  • The last payment to investors on 12 July 2021 will be the repayment of the $100 face value of the bond plus interest for the final quarter.

 

Enhancing cash allocation

With interest rates on cash products so low, investing in cash can compromise your wealth. That’s because your capital may be eroded by inflation, which is often running higher than interest rates on cash products, particularly savings accounts.

The Consumer Price Index is currently 1.8 per cent per annum. With most cash management accounts yielding around 1.5 per cent per annum or less, that means that the value of an investor’s money in such an account would be falling by 0.3 per cent a year.

FRNs are an effective enhancement for cash investments as they potentially offer higher yields than cash. As their coupons are ‘floating’ and reset every quarter, their yield rises with market interest rates, hence the potential for higher yields comes with an ‘interest‐rate risk’ profile similar to cash. 

Therefore, FRNs are more like cash than they are like fixed rate bonds.  

The yield on the benchmark FRN Index, the Bloomberg AusBond Credit FRN 0+ Yr Index, was 2.66 per cent per annum as at 31 October 2017, which compares favourably to the most cash management accounts.

In addition, the average interest rates on a 1‐year bank term deposit was just 2.25 per cent in September and just 1.95 per cent for a 6‐month term deposit, according to data from the Reserve Bank. FRNs compare favourably.

The chart below highlights the outperformance of FRNs since the global financial crisis, with the return on cash measured by the Bloomberg AusBond Bank Bill Index.

The other challenge with savings accounts and term deposits is that banks and other financial institutions don’t necessarily pass on rate rises and term deposit rates which are fixed and can be lower than the yields on FRNs. 

 

Benefits of FRNs

The key benefits of FRNs can be summarised by the three following points: 

Potential protection against rising rates ‐ When interest rates go up, a FRN’s coupon rises.   Additionally, due to the coupon resetting regularly, the price of a FRN will remain relatively steady given the coupon will reset at a higher interest rate.

Potentially attractive yield compared to bank bills and cash funds ‐ Coupons are typically reset on a quarterly basis and go up with short‐term interest rates. Hence, FRNs are a good potential alternative investment to term deposits and other cash investments which are 

Investing directly in FRNs is difficult ‐ Usually FRNs are only accessible to institutional investors, they are traded off‐market and often require a large minimum investment size.  One effective and low‐cost way to invest a diversified portfolio of FRNs is via an exchange traded fund (ETF).  

 

Defensive quality of bonds

In addition to their valuable income streams, bonds are considered defensive investments because they tend to do relatively well when share markets correct. In times of economic downturn or financial market instability, investors typically switch out of equities into bonds, including FRNs, because of bonds’ relatively stable returns. 

The graph below shows the strong outperformance of Australian bonds during the global financial crisis (GFC) compared to equities. You can see that in 2008, share prices fell nearly 40 per cent while Bloomberg AusBond Composite 0+ Yr Index, which includes government and corporate bonds, rose around 15 per cent. That’s a huge outperformance by bonds. The second chart displays the greater capital stability of bonds compared to equities. Over 10 years to 30 June 2017, the return on bonds easily outstripped the return on the S&P/ASX 200 Accumulation Index, which returned 3.30 per cent per annum. 

FRNs, using the benchmark Bloomberg AusBond Credit FRN 0+ Yr Index as a guide, returned 4.37 per cent per annum while corporate bonds did even better, with the benchmark Bloomberg AusBond Credit 0+ Yr Index, returning 6.36 per cent per annum over the same 10 year period.

So bonds did a lot better than Australian equities, which dived during the GFC and took almost six years to recover. Bonds withstood the assault and came out post the GFC performing much better. 

That’s why it is important to include bonds in a well‐diversified portfolio. For investors, this diversification is important for two reason. First, it enables investors to reap a decent yield from a portion of their investments. Second, bonds provide a valuable defence to capital loss during financial market volatility.

With the yield on the Bloomberg AusBond Credit FRN 0+ Yr Index sitting above interest rates on many term deposits, cash management and savings accounts, FRNs offer an effective cash enhancement.  

 

Russel Chesler is the head of investments at VanEck.

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