Opinion – Floating rates offer fixed income complement

17-Jul-2017

By David Bassanese

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In today’s world of very low interest rates, investors face a challenging trade-off in seeking decent income returns outside of the volatile equity market. While cash and deposit products offer relative security and liquidity, returns are currently very low.

The typical fixed income fund also offers less than spectacular income returns, thanks to very low yields on government bonds. These funds also face the risk of some capital loss for a period as bond yields eventually rise to more normal levels.

Against this challenging background, a potential sweet spot for investors in terms of risk and return is high credit quality floating rate bonds (or FRBs) issued by our major banks. After all, Australian banks remain among the most profitable and highly capitalised in the world.

The risk-return advantages of senior bank FRBs stem from their mainly floating interest rate structure and high credit quality. As distinct from “fixed rate” bonds – where nominal regular interest payments are fixed over the life of the bond – variable or “floating rate” bonds have their interest payments reset at regular intervals to reflect the prevailing level of market-determined interest rates.

Accordingly, the market value of floating rate bonds is much less sensitive to changes in the general level of interest rates, and therefore has lower interest rate risk compared with fixed rate bonds. Indeed, history shows FRBs have tended to outperform fixed rate bonds in periods of rising interest rates.

As and when low global bond yields eventually rise to more normal levels, this will tend to hurt the returns of fixed rate bonds and bond funds that track fixed rate bond indices, such as the Australian benchmark Bloomberg AusBond Composite Index.

Another positive feature of senior bank FRBs is that they rank fairly high in the corporate capital structure, meaning their credit risk is relatively low. In the unlikely event of a bank default, for example, FRB investors are lower in the credit chain than investors in traditional cash and term bank deposits, though still rank ahead of investors in bank unsubordinated debt, hybrids and, of course, shareholders.

In terms of income, moreover, an index of Australian Bank floating rate bonds as at the end of May offered an annualised income return of about 1.3 per cent per annum higher than that generally being offered by the major banks’ online savings accounts, and about 1 per cent per annum higher than the rate generally available on one month bank term deposits. And unlike term deposits which require investors to lock up their money for one or more months, ASX traded ETFs that track such an index effectively offer investors access to their money within two days should they need it back.

All up, especially in today’s environment of very low global interest rates, investing in floating rate bonds as an alternative or complement to fixed rate bonds seems to make particular sense.

David Bassanese is chief economist for ETF provider BetaShares

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