How to ride interest rates with floating rate notes

Co-founder of the Switzer Report
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Pundits of all sorts are debating whether we’ll get an interest rate rise or a rate cut, and when it will come.

While we here at Switzer think interest rates are on the way down, others in the market have a different view. Last week’s unexpectedly high inflation figures caused ANZ to tip that the Reserve Bank will hike its benchmark rate to 5% from 4.75% tomorrow.

In our 25 July edition of the Switzer Super Report, we looked at some fixed interest bonds that can be purchased on the Australian Stock Exchange (ASX). However, if you’re of the view that rates will rise, you may be interested in an alternative to this type of investment. So today, let’s look at ‘floating rate notes’.

Like a fixed interest bond, floating rate notes have a fixed maturity date, however the interest rate that is paid for each period varies (or ‘floats’) relative to a benchmark interest rate. This benchmark is usually the 90 day bank bill rate, which is the wholesale rate that major banks use when they lend to the most credit worthy corporate.

When floating rate notes are issued, the interest rate is fixed as a margin to the benchmark rate. While the margin remains fixed throughout the duration of the note, the underlying rate floats, meaning that the interest rate received every 90 days varies. At the start of every period, the benchmark rate is determined by the issuer, the fixed margin is added and the interest rate calculated for the next payment date in 90 days.

For example, if a floating rate note pays 2% over the 90 day bank bill and the current 90 day rate is 4.95%, the next interest payment in 90 days will be at an effective annual rate of 6.95% per annum.

The price of a floating rate note in the secondary market will vary depending on the attractiveness of the fixed margin on the existing note compared with the margin that new borrowers of a similar grade are being asked to offer.

For example, if an existing note was issued at a margin of 2%, and new borrowers of a similar credit quality are being asked to offer a margin of 2.5%, then the price in the secondary market for the old note is likely to be less than $100. Of course, the usual supply and demand factors will also come into play, as well as any perceived change in the issuer’s capacity to repay the principal.

Floating rate notes are good alternatives to term deposits for SMSFs seeking higher returns and that are prepared to take some more risk. There is credit risk on the issuer – and of course, no government guarantee. With a fixed margin, there is no ‘re-investment risk’ – an issue that term deposits investors face each time they rollover from one term deposit to the next. Liquidity is arguably a lot better than that of a term deposit.

Below are some of the notes available on the ASX.

Tip: If you’re willing to take some credit risk, the Primary Heath Care notes look like reasonable value. While Primary Health Care Limited (ASX:PRY) is carrying a lot of debt, there is nothing in the way its share price has been trading over the past six months  to suggest that the market is too concerned. Commonwealth Bank’s (ASX:CBA) floating rate notes look expensive (there’s better value in term deposits), and Tabcorp Holdings (ASX:TAH) has some appeal.

CBA note
Primary Health note
Tabcorp note

Also in Monday’s Switzer Super Report:

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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