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Craig Simpson asks should bond investors be looking to buy fixed rate or floating rate notes right now?

Craig Simpson asks should bond investors be looking to buy fixed rate or floating rate notes right now?

By Craig Simpson

Much has been written lately about interest rates, with experts hypothesising around what the Reserve Bank (RBNZ) will do, when the first rate hike will come and what impact this will have on households with mortgages coming up for a rollover.

Next to nothing has been written on whether bond investors should be buying up floating rate notes or fixed rate bonds in the current environment.

Last week both Westpac and ASB issued floating rate notes and at the same time ASB also came out with a five-year fixed rate bond with basically the same maturity as the floating rate note (give or take a couple of weeks) and with an identical indicative margin, albeit it over a different benchmark (5-yr swap vs 3-month bank bills).

I found myself pondering: Was it better to buy the floating rate notes or the fixed rate securities at the moment?

Scars from the past

I should disclose to readers that I do hold some ASB redeemable preference shares (resettable securities), which were purchased in 2008 (from memory) and still hold my original 'investment' to this day. My own situation is different to many as I just wanted a place to park some spare cash and I didn't specifically need the additional income.  

Others however were not as fortunate and found themselves holding these securities following the global financial crisis (GFC) and the protracted fall out.

I know of many financial advisers and their clients who have purchased resettable securities at the top of the interest rate cycle thinking rates could go higher, only to find they did the exact opposite and very quickly.

During the period April 2008 to April 2009, the RBNZ cut the OCR from 8.25% to 2.5%. The severity of the rate cuts meant over the next one to two years investors who had been enjoying income at 9% were finding they were now only getting 4% and 5% and even more recently around 3%.

These same investors could have sold their bonds. But with the likelihood of diminishing income streams, the capital values were discounted by the market - so many sold at a capital loss rather than ride the wave hoping to come out the other side once the storm finally abated.

Many current investors will undoubtedly still be hurting from their recent unpleasant experiences. With the benefit of hindsight and lessons learnt, is now the time to reconsider consider getting back into the floating rate water?

For a list of current floating rate and resettable securities you can click here to go to our bond indicative pricing page.

Crystal ball gazing

Before getting into either fixed rate or floating rate securities ('floaters') we need to consider where interest rates might be heading and how quickly any movement may be.

The market has a widely held expectation that interest rates will rise. The timing of these rises is debatable but odds are it will be later in 2013 or early 2014. 

Forecasts from the four major bank economics teams are shown in the table below and indicate by early 2015 the OCR could be somewhere between 3.5% to 4.25%.

The spread of OCR forecasts into late 2014 and beyond is quite wide, with BNZ coming out as the most aggressive in their forecast for the future OCR track.

It will be interesting to see if these forecasts come closer together over time or continue to diverge.

  Mar-13 Jun-13 Sept-13 Dec-13 Mar-14 Jun-14 Sept-14 Dec-14 Mar-15
ANZ 2.50% 2.50% 2.50% 2.50% 2.75% 3.00% 3.00% 3.25% 3.50%
ASB 2.50% 2.50% 2.50% 2.50% 2.75% 3.00% 3.00% 3.25% 3.50%
BNZ 2.50%     2.50% 2.75%     4.00% 4.25%
Westpac 2.50% 2.50% 2.50% 2.50% 2.75% 3.00% 3.25% 3.50% 3.75%

For more crystal ball gazing from the economists refer to the fixed v floating mortgage story on our website.

Cash flow considerations

It is a given that investors looking for income will generally be purchasing bonds for the surety of cash flow.

The big unknown for floating rate note holders is what the base rate will be when the bonds reset. There is a high degree of interest rate risk here as the bond coupon (interest rate) could be higher or lower than you are already receiving.

When it comes to floating rate notes (or resettable securities) the income stream is certain for a limited period (normally three months or one year) and will adjust at a predetermined interval and margin over a specific benchmark. Whether that is a swap rate or bank bill it really doesn't matter.

For those on tight budgets or with specific income requirements, floating rate notes make predicting income streams more difficult. It may not be suitable to include these securities in your portfolio.

There are currently many floating rate notes or resettable securities available, each with their own quirks, differing maturity dates and reset margins.

According to ASB's parent CBA the market is pricing-in an aggressive RBNZ tightening cycle, which by the end of 2014 is likely to see NZ rates nearly a full 1% above the forecast RBA's rate.

There is always a risk that an extra-ordinary event occurs and interest rates trend downward again.

Opportunity cost

If you are going to invest in floating rate notes compared with a fixed rate bond there is an opportunity cost.

Take for example the latest ASB issue. The fixed rate notes were set the other day at a coupon of 5.06% p.a. for five years. The floaters are likely to be priced somewhere around 3.75% for the first three months and then reset. 

For the floaters to be preferred on an income basis only the interest rate would have to be above 5.06%. This would require the base rate to rise to at least 4% and add to this the margin of 1.10% (110 bps). 

From a pure income perspective investors are more likely to prefer the fixed rate notes in the short term but longer term may look to switch to the floating rate securities when the base rate gets above 4%. 

Looking at the interest rate forecasts from the banks, assuming the OCR (which I have used as a simple proxy for the base rate) hits 3% this time next year, the opportunity cost is going to be around 1.3% for the first 12 months - this is crudely calculated using the current fixed rate coupon of 5.06% - the average expected OCR over the next four quarters + the margin of 1.10% each quarter (which came out to 3.7875%) = 1.2725%.

The actual difference may be higher or lower depending on what the base interest rate does each quarter.

Extrapolating this out further, if we take the lowest of the four bank OCR forecasts for March 2015, and apply 1.10% to this the interest rate would only be 4.6%, still around 50bps beneath the fixed rate coupon.

BNZ's forecast of an OCR at 4.25% by March 2015 would have to come to fruition and stay there (or go higher) for the balance of the term before investors would possibly be better off in floating rate notes. 

If you take into account that in the first year the opportunity cost of fixed over floating is probably going to be around 1%, then the headline interest rate for the floater would have to be at least this amount over the fixed rate security to compensate.

The final decision

The decision to buy fixed rate or float rate securities is going to follow a very similar process that many households go through when they look at their mortgage.

You form a view on interest rates, you take advice from experts, do your own reading and analysis, weigh up the personal situation and go with the option that sits most comfortably with you.

I don't regret the decision I made to buy a resettable security all those years ago as it was right for me at the time.

One saving grace for bond investors is if they stick with investments that are on a recognised exchange and are frequently traded they can change their mind and switch from fixed to floating ( or vice versa) for a small brokerage fee. It is harder and more costly to do this with a mortgage part way through its agreed term.

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Next to nothing has been written on whether bond investors should be buying up floating rate notes or fixed rate bonds in the current environment.
I guess when the choice is fixed or floaters offered by New Zealand registered banks one should be asking a whole lot more questions.
Why is the O/N FX-swap implied NZD interest rate so far above OCR?
For instance midpoint  NZ/USD pips for the 17th July NY close
-  ((0.46+0.89) / 2) x 365 = 246.375
-  (246.375 / NZD/USDx10,000: 7901) x 100  = 3.1183%
- 3.1183% + US Libor O/N 0.1177% = 3.236%
Place this in the context of the points made in this BIS article entitled:
The spillover of money market turbulence to FX swap and cross-currency swap mark
and note the risks in a further BIS article, concerning the proliferation of collateralised currency swaps undertaken by our banks. Even interest rate and Stuff have noted problems, here and here.
Asset encumbrance, financial reform and the demand for collateral assets
Increased collateralisation of bank balance sheets mitigates counterparty credit
risk, but adds to the procyclicality of the financial system. The channels through
which this occurs, in times of financial stress, are the exclusion of certain assets
from the pool of eligible collateral, higher haircuts on collateral assets,
increased margin requirements on centrally cleared and non-centrally cleared
derivatives trades and marking-to-market of bank assets in collateral pools.

Greater encumbrance of bank balance sheets can adversely affect the residual
claims of unsecured creditors during bank resolution,
increase risks to deposit
insurance schemes and reduce the effectiveness of policies aimed at bail-in.
Given limited disclosures on encumbered assets, the ability of markets to
accurately price unsecured debt can also be impaired.

Is the investing public really aware of the risks associated with unsecured bank debt purchases?

What in the world is going on?! As I write this letter from the Maine woods, the S&P 500 has just cleared 1,700 for the first time. The German DAX continues to set all-time highs above 8,400. The United Kingdom’s FTSE 100 is quickly approaching its 1999 record high of 6,930, and its mid-cap cousin, the FTSE 250, just broke through to its all-time level above 15,000. And last but not least, Japan’s Nikkei 225 is extending its gains once more, toward 14,500.

I assume the recent "improving" employment data etc plus Bernankie back peddling has the "rational" markets humming.
Plus, where else is there to put it?  most "investors" probably think shadowstats is right so dont want to lose out to inflation in low yeilding anything. Bonds look like a blood bath at some point, possibly soon, plus well frankly you have to consider the US banks downright fraudelant, hedge funds are apparently struggling, where else is there to go with your "hard earned" err I mean borrowed wealth? to make a pile?
or just think tulips...

Interest rates will remain low for the short & medium term. 
Fix for investment. Float or shortterm fix for borrowing. 

short 18months?
medium 3 years?
When the US U6 which is real un-employment is 14% even 3 years seems optimistic to get back to 4~5%...

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Days to the General Election: 39
See Party Policies here. Party Lists here.