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Written by Faxts Media Published: February 27 2018 Major
RIM Securities analysis of Australian fixed income portfolios suggests investors are hedging the possibility of rate increases and boosting returns while interest rates remain stable at low levels.Floating rate coupon bonds with A- or below credit ratings serve this purpose.
Capital gains might eventuate if the corporate bond risk premium (i.e. risk premium) narrows further. Of course, fixed interest rate bonds would experience bigger capital gains under the same scenario and exposure to bigger losses if interest rates were to go up.
The need to trade-off risk for return is a factor in all portfolio management decisions.
Risk premium squeeze
Below, the chart shows the extent to which the risk premium decreased as the shock of the Global Financial Crisis (GFC) started to dissipate in 2009.
The notion of risk premium is important in portfolio management. Government securities are considered to be risk-free while corporate bonds are associated with higher levels of credit risk and lower liquidity. Corporate bond issuers must therefore promise higher returns to attract investors. The risk premium is the difference between the risk free government and the corporate bond yield.
Credit risk ratings
Australian government debt is rated AAA (1) and represents the lowest credit risk and highest liquidity available in Australia and indeed it ranks amongst the safest in the world. Note, Standard and Poor’s holds a negative outlook for Australian government bonds. Many AAA rated bonds disappeared in the ravages of the GFC leaving a smaller variety of risk free bonds.
Credit ratings estimate the probability an issuer will be unable to meet the bond’s coupon and principal commitments. Bonds are grouped into categories based on their default and loss probability. Standard and Poor’s AAA represents the highest probability the issuer will meet their commitments.
Desperate for yield and certainty
Persistent low interest rates might have forced investors who depend on regular bond coupon payments (e.g. retirees) to assume higher credit risks. The relative increase in demand should push the price of the bonds higher and by definition lower the yield at a time the risk free yield curve is stable, especially if supply does not increase in line with demand. The risk premium narrows as a result.
The latter would make more sense given the memory of the GFC is yet to fade. The Reserve Bank of Australia (RBA) chart also shows corporate bonds rated A or below experienced bigger swings since 1998. That’s great when rates are falling but results in bigger capital losses when rates are on their way up.
Low interest rates are key
On the 2nd of May 2017, the RBA decided not to change the interest rate (2).
RBA Governor Philip Lowe acknowledged the role of low interest rates and the lower exchange rate in supporting their growth outlook. Exchange rates are a function of interest rates so lower interest rates are at the core of the growth outlook.
The RBA Governor’s statement expressed confidence in the ability of the recently announced supervisory measures to help address the risks associated with high and rising levels of indebtedness and pointed to the higher mortgage rates paid by investors and on interest-only loans. Market commentators have referred to the mortgage interest rate increases as ‘out-of-cycle’ because they occurred even though the RBA left the cash rate unchanged.
Consider the extent to which the lower AUD coincides with the smaller differential between the US and Australian government bond spreads as shown in the RBA’s graph above. The RBA might fear higher interest rates will lead to a higher AUD and they are hoping the supervisory measures will quell mortgage growth.
RBA Governor Philip Lowe noted the following in his statement (ibid).
Higher interest rates pose an immediate risk to growth but prolonged lower interest rates pose the risk of financial instability down the track.
The RBA monetary policy statement appears to be a rationale for steady interest rates.
Hope for a rate rise
Perhaps the US will give the RBA room to tighten monetary policy in the next two years.
What would happen if the US President managed to maneuver corporate tax cuts and a massive infrastructure program through Congress and Senate?
Interest rates are a function of the expected inflation rate. In the first instance, these two initiatives would massively increase the US budget deficit and inflationary expectations. Higher US interest rates could reasonably be expected.
What if the Australian Federal Government fails to assure financial markets that our own budget deficit is under control with the delivery of the Federal Budget?
FinTech innovation expanding choices
For the moment, the challenge remains. Retail investors (e.g. SMSFs) have far more difficulty accessing bonds than their institutional competitors. Competition is fierce. Thankfully, FinTech innovation is making it easier for SMSF investors to select a bigger variety of bonds.
Please give us a call if you are interested in finding out more about investment opportunities for your portfolio.
The author of this Blog from FaxtsMedia specialises on online journalism and draws on the expertise of financial markets professionals with years of experience at the global and local level.