Interest rate movement unknowns vs. known fixed rate bond returns

Print This Post A A A

Recently, the OECD downgraded the growth forecast for Australia to 2.6% in 2013, from 3.0% just six months ago. The prior forecast made a year ago was 3.7%. Lower growth reinforces our view that interest rates will be lower for longer.

FIIG’s economist Dr Stephen Nash expects “a further 0.25% cut to 2.5% to the official cash rate, but if growth starts to moderate in the US, more than expected, the cash rate could fall further”. Assuming US growth remains on track, Dr Nash expects the cash rate to remain at 2.5% for the 2014 year.

Bill Evans, Westpac’s chief economist, is more pessimistic, “we retain our position that the terminal cash rate will be 2.0%, with single moves in August, late 2013 and early 2014”. He expects rates to reach a record low of 2.0%. Admittedly, he made these remarks before Federal Reserve chairman Ben Bernanke’s comments last night.

The Reserve Bank (RBA) has clearly left the door open for further easing, with the statement from 4 June 2013 concluding with the following paragraph:

At today’s meeting the Board judged that the easier financial conditions now in place will contribute to a strengthening of growth over time, consistent with achieving the inflation target. It decided that the stance of monetary policy remained appropriate for the time being. The Board also judged that the inflation outlook, as currently assessed, may provide some scope for further easing, should that be required to support demand.

QE effect

Against this backdrop of potentially lower RBA cash rates in the short term, long-term interest rates (or yields) have actually risen in recent weeks. This has primarily been due to growing anticipation that quantitative easing (or QE) is closer to ending in the US. QE is primarily conducted via purchases of long dated US Treasuries and Agency debt. If/when this ends, the simple reduction in demand will see prices fall, and with an inverse relationship between the price of fixed rate bonds and yields, the latter will rise.

While this is a US based dynamic, the effects have been felt in Australia. Before last night’s announcement by the US Federal Reserve, the yields on five and 10-year Commonwealth Government bonds had risen by 13 basis points and 17 basis points respectively over the last two weeks, creating better value in long dated fixed rate corporate bonds.

The emphasis of market commentators on dividend yield or share income has meant we’ve started to focus a little more on running yield (the income you would expect to earn in the next year) given it is more equitable. Think of yield to maturity (income plus the capital gain or loss at maturity) being a worst-case, however known, scenario.

Keep this in mind

Having said that, investors must remember the simple inverse relationship between yield and price and consider if this suits their circumstances. When interest rates fall, the price will increase, however when interest rates rise, the price will fall. The difference however, when compared to most other asset classes, is that on a hold to maturity basis you will get the exact return you expected when you purchased the bond. If this dynamic poses an unwanted risk, investors may be better suited to floating rate or inflation linked bonds, which tend to be less volatile and typically increase in value when interest rates and/or inflation are rising

Table 1 shows a range of fixed rate bonds with a running yield of 5.4% or more. Many of the bonds are showing a yield to maturity in excess of 5.5% and a running yield of over 6%.

All prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities.

Important: 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. Consider the appropriateness of the information in regards to your circumstances.

Also in the Switzer Super Report

Also from this edition