I was lucky enough to attend the recent Economic Society lunch in Brisbane and hear the speech by Reserve Bank Governor, Glenn Stevens. He gave little away regarding the direction of interest rates, although there were quite a few inventive questions designed to trip him up.
One of the key takeaways was Stevens’ insistence that for there to be another rate cut, it would have to provide sustainable growth. This is a tough proviso. While I think there is still capacity for further cuts, a 2 per cent cash rate could well be the low point of this cycle.
Coupled with the volatility in the longer term benchmark 10 year government bond rate, it may be time to change the emphasis of your bond portfolio to be weighted in favour of floating rate bonds.
If you haven’t yet invested in bonds, here is a brief outline of the floating rate variety.
Floating rate bonds are just as the name suggests. Interest is paid to you on a quarterly basis and floats up and down with economic conditions. If the market expects interest rates to rise, then income on these bonds would be expected to rise, providing a strong reason for investors to purchase.
No wonder so many of us hang on every word of the Governor’s speeches!
More specifically, floating rate bonds pay interest linked to a benchmark such as the Bank Bill Swap Rate or BBSW. Take for example NAB subsidiary National Wealth Management which has a floating rate bond. This bond was launched in 2006 with an interest rate of 90 day BBSW plus 0.63 per cent. On the day it was launched, the BBSW was recorded and added to the fixed margin of 0.63 per cent to determine the interest payment for the coming quarter. As the actual BBSW was 5.98 per cent, the interest for the coming quarter would have been 5.98 per cent +0.63 per cent = 6.61 per cent divided by 4, to get the quarterly rate.
Three months later the interest would have been paid on the bond and the BBSW rate taken that same day would have been used to calculate interest for the coming quarter.
Of course, now the 90 day BBSW is much lower at around 2.15 percent, so interest on the bonds is also lower.
Thus interest on floating rate bonds goes up and down. Because these bonds are responsive to market conditions their prices are more stable than the fixed rate or inflation linked bonds, which is an attractive feature for investors who may want to sell prior to maturity.
Some of the current attractive floating rate bonds include:
- Low risk, National Wealth Management bonds with a first call in June 2016, yielding 90 Day BBSW + 1.50 per cent, with a projected yield to first call of 3.60 per cent
- Investment grade Dalrymple Bay Coal Terminal bonds maturing in June 2021 yielding 90 Day BBSW + 1.90 per cent, with a projected yield to maturity of 4.8 per cent
- High yield Dicker Data bonds maturing in March 2020 yielding 90 Day BBSW + 3.98 per cent with a projected yield to maturity of 6.67 per cent
Stevens commented that he thinks rates will be low for a long time, so it’s still fine to hold onto your fixed rate bonds as they do offer complete income certainty.
Please note this article originally appeared in The Australian and rates are accurate as at 11 June 2015, subject to change.
