Interest-Bearing Securities: Remain an Attractive Option for Investors in 2019

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By

Paul Ashworth, Managing Partner
David Clark, Director
Tristan Bowman, Manager


Posted 11 February 19

Interest-Bearing Securities, or Bonds, provide a key source of income and portfolio ballast to any asset allocation, an importance that has been highlighted by the market turmoil of 2018.

Over the past 12-months in Australia, we have seen a flattening of the yield curve, which is the outcome of two significant trends; short-term yields increasing and long-term yields falling, a process known as bear flattening. This trend is favourable for short duration, floating rate securities.

Interest Rates

The RBA headline interest rate has now been on hold at a record low of 1.50% since August 2016, with the last rate increase way back in November 2010 – over eight years ago. At the beginning of 2018, market participants were forecasting two rate rises by mid-2019 (the medium green upward curve) with many of the bank economists more bullish than the market. As of the end of 2018, the market is pricing in the ‘lower-for-longer’ mantra with no change by the RBA for the foreseeable future (light green line).

Despite no movement in the RBA rate, the 3-month Bank Bill Swap Rate (BBSW) has climbed to 2.0% and is trading at the largest gap to the RBA rate since 2012. The BBSW is the short-term rate that major banks lend to each other, so the increase reflects a rise in perceived credit risk of the big banks due to the headwinds facing the sector; higher overseas funding costs, a slowdown in property prices (and credit demand) and potential regulatory outcomes from the Banking Royal Commission.

Implied yield on 30-day inter-bank futures

RBA Cash Target and Futures Pricing

Bank Bill Swap Rate

The BBSW is highly important to the Australian bond market as it is used to calculate the interest payments on most floating-rate securities issued by corporates, financial and non-financial. Given this relationship, the recent uptick in the BBSW has increased the return on floating bonds by 25 bps, making them more attractive to investors. The simultaneous increase in bond yields and equity market uncertainty further improves the attractiveness of interest-bearing securities, in particular, non-financial corporate debt.

The non-financial corporate debt market in Australia has not experienced the same scale of expansion that has occurred in the US and Europe. Domestic corporates have preferred to raise funds through equity issuances that have led to the ratio of Debt/Equity fall since 2015. We believe that population-driven Australian growth and lower-for-longer rates will support non-financial corporate balance sheets and keep bankruptcy rates low. Coupled with the rising benchmark rate, this is a sector that warrants increased exposure.

Economic and Investment Strategy

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This article is part of our 2019 Economic and Investment Strategy Guide and one such starting point in our highly considered process that will ultimately manage downside risk and maintain the real value of capital.

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