This article has been submitted by Income Asset Management
In consideration of further rate increases from the RBA, fixed income markets are largely ‘pricing in’ the current rate hike cycle. Whether the market is right or not is another matter and often hard to predict. The market will form a path on forward rates expectations based on the outlook from the RBA, view on local inflationary dynamics, and global central bank activity.
Typically, investors will favour floating rate notes (FRNs) over fixed coupon bonds during a rate hike cycle as the coupon on FRNs ratchets upwards as rates increase. Conversely, fixed coupon bonds decline in value.
As such, if the RBA doesn’t raise rates as fast as the market expects then the returns on FRNs would decrease. However, if the RBA raises rates in line with the market and/or higher even, then FRN returns are improved. With this uncertainty involved, it is worthwhile having a diversified portfolio across FRNs and fixed coupon bonds to act as protection when markets melt down. Either way, the outright yields available to investors right now can help to manage the detraction caused by inflation.
Below we discuss the merits of an FRN by using the Ampol subordinated notes (ALDAU 0 12/09/2080) as an example of high grade, BBB-rated security.
Also read: Is It Time To Buy Bonds Now?
This bond pays a coupon of 3.6% above 3m BBSW and is callable in March 2026. Coupons are paid quarterly – in March, June, September and December respectively. In September 2021 (only 1 year ago), this bond only paid a total coupon of 3.6%. However, the latest coupon (September 2022), has ratcheted upwards to a significant 6.2%. The increase in coupon of around 2.6% from last year is purely a result of 3m BBSW being reset as rates increase. For an investor, holding this bond results in higher income from their fixed income allocation. Many investors have struggled to be able to draw down this as an income stream for many years without eating into their capital.
Below is a table of the past coupon resets on the Ampol Subordinated notes (ALDAU 0 12/09/2080) as well as the current Australian Bank Bills Curve.
Past Coupon Resets
Accrual Start |
Rate |
| 12/9/22 | |
| 9/9/22 | 6.209900 |
| 6/9/22 | 5.083100 |
| 3/9/22 | 3.745800 |
| 12/9/21 | 3.660700 |
| 9/9/21 | 3.610400 |
| 6/9/21 | 3.625000 |
| 3/9/21 | 3.638800 |
| 12/9/20 | 3.620000 |
| Source: Bloomberg |
Australian Bank Bills Curve
Source: Bloomberg
The chart below shows the 30-day cash rate futures curve until the end of 2023. Currently, the market is expecting rates to reach 3.9% by June 2023. In June 2023, a coupon reset with a margin of 3.6% would give a return of 7.5% (3.6%+3.9%). This is a very healthy return for a BBB-rated security in 9 months time.
Furthermore, the expected return on the Ampol subordinated notes looks very good into the future. The notes are callable in March 2026 so have an expected life of 3.5 years. The 3- and 4-year bank swap curve is currently sitting at around 3.85% (3.78%-3.93%). So based on a 3.85% bank swap curve and 3.6% margin, this note may earn 7.45% (3.6%+3.85%) into the future. This is commonly referred to as the yield to maturity (YTM) on a security. For context, 1 year ago the 4- and 5-year bank swap curve was between 0.6-0.8%. The notes would have had an expected life of 4.5 years (being 1 year longer in life). Thus, the notes would have had a YTM of 4.3% (3.6%+0.7%) – this is a massive 3% less than the current YTM.
A reminder for investors, the credit risk of Ampol still needs to be assessed and monitored carefully.
With all the focus on the cash rate, many investors do not always realise how much medium and long-term bond rates can move very quickly ahead of short-term rates. Nonetheless, short-term rates have now somewhat caught up creating income opportunities not seen for decades. Although some investors might shy away from adding fixed coupon bonds given the current rate hike cycle, it’s worth acknowledging they currently provide an opportunistic entry point with many bonds trading at a discount to par. If we see a recessionary scenario play out, then we could see upside on those fixed coupon bonds as the curve should flatten and even invert (all-else-equal). Both in Australia and the US, markets are now pricing in rate cuts to start from the middle to late 2023.
Below is a table of the Australian Dollar Bank Swaps Curve as of 20/09/2022.
