Australia | May 02 2012
By Greg Peel
Many investors, particularly those reliant on investment income such as self-funded retirees, hold cash or term deposits (TDs) for safety and certainty – a perfectly reasonable strategy in the eyes of fixed income specialists FIIG. But if TD rates move lower the risk is income will not be sufficient to cover lifestyle costs and choices, meaning capital draw-downs are in the offing.
We have just had a 50 basis point rate cut from the RBA. The banks are no longer battling each other to secure deposits given: (1) offshore funding costs, while still elevated, have declined; (2) deposit holdings at banks are now much higher than they were and at comfortable levels; and (3) with little prospect of decent loan growth the banks can no longer afford to sacrifice margins. The banks have already been reducing the “teaser” premiums on their TD rates and over twelve months the RBA has dropped its cash rate by a full 1%.
The banks will likely now reduce their TD rates by all, or at least most, of the 50 basis point cut.
The following graph from FIIG demonstrates what happened last time their was a rapid decline in the RBA cash rate, being that of the 2008 GFC response. Before the GFC the cash rate was 7.25% and the banks were offering a 7.90% TD rate on average (65bps premium) but by the end of 2008 the cash rate was 4.25% and the TD rate 4.37% (12bps premium).
One way to limit or prevent loss of income through falling interest rates is to buy fixed rate bonds, suggests FIIG, where the return is known for the life of the bond. When interest rates fall, fixed rate bond prices rise because the higher fixed rate is more attractive, providing capital gain potential. (And the opposite is true when rates rise). A fixed rate bond is marginally more risky than a TD, but only one more level down the capital structure (in which equity is lowest).
Senior corporate and major bank fixed rate bonds can achieve three positive outcomes in a falling interest rate environment, notes FIIG: (1) income is at least as good and usually better than that offered by a TD; (2) there is a potential for capital gain; and (3) the investor's return is known over a longer period (8 plus years).
Clearly point (3) can work against the investor if within the life of the bond interest rates turn back up again and the fixed bond rate then looks inferior. However the sensible allocation of some part of a portfolio into bonds can leave remaining room for flexible investment. And fixed rates provide that “sleep at night” factor.
Major Australian fixed rate senior bonds returned over 10% for the past twelve months, FIIG notes. On average, the bonds of the big banks have returned in excess of 10% over the period on a total return basis, or 4.00% above the TD return (more compared to equity dividend or hybrid coupon returns). The reasons for such outperformance of one form of investment asset within the capital structure of the same bank, suggests FIIG, have been the changing interest rate environment in Australia and an investor flight to quality given global uncertainty.
Outside of the big banks, FIIG highlights three senior bond preferences being Praeco (2020 maturity, 7.13% coupon), Dalrymple Bay Coal Terminal (2016, 6.25%) and Suncorp Metway Insurance (2014 first call subordinated, 6.75%).
“In summary,” says FIIG, “don't feel that you need to stay in cash or TDs to protect your capital. Returns from fixed rate bonds will allow you the comfort of knowing your income over a defined period, with the added benefit of capital gain if the economy continues to slow and the RBA continues to cut the cash rate.”
Investors must nevertheless be aware that corporate fixed interest bonds are usually issued on large face value units which may be unsuitable or out of the reach of the smaller investor.
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