Fixed vs floating? How to get a return of over 8.5%

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One of the most frequently asked questions I get about fixed income is whether an investor should be buying fixed rate or floating rate bonds. With the Reserve Bank of Australia’s (RBA) interest rate cut this week once again bringing this front of mind, I will look at what investors should consider and offer an example of particularly good value available in the market currently.

First, it is worth noting what happens to a fixed rate bond in a falling rate environment. I often use a see-saw analogy to explain how fixed rate bonds work and to show this I will use a very basic example where a $100 bond is issued at a rate of 5%.

If interest rates are then cut to 4%, the price of the fixed rate bond must adjust to reflect this, the original bond has not changed, it still represents the same risk, but the rate of interest investors are prepared to earn (as dictated by the RBA) has changed so holders of the original bond are effectively repriced to reflect the new market reality of 4%. This is just a matter of maths.

When rates are cut, the capital value of the fixed rate bond goes up. Similarly, when rates increase, the capital price of a fixed rate bond will fall.

As the name suggests, floating rate bonds float up and down with the underlying interest rate benchmark, so the capital price is not similarly affected by changes in rates.

When value appears

With the economy slowing and the RBA in a mood for rate easing this year, we have seen investors rush for fixed rate bonds as they seek to lock in returns before the next cut. This move to fixed rate notes is not dissimilar to the move to high yielding stocks on the ASX over the past six months – and both strategies have paid off for investors.

However, the rush to fixed rate bonds has in some cases left the equivalent floating rate bond behind, creating value anomalies in the market. Whilst the surety of a fixed return is attractive, where the market sentiment has over run the reality, the value will appear in the floating rate bond. This, rather than whether the RBA has one more cut in its kit bag, should be the driver of investment decision.

A high yield, high value example

The flight to fixed rate returns is clearly shown in the case of AXA’s Tier 1 hybrid. AXA SA is one of the world’s largest insurers and with a market capitalisation of almost €30 billion (A$37.5 billion), it is one of the largest companies on the French stock exchange. Whilst it is a diverse company, AXA mainly operates in the low risk insurance lines of Life, Property & Casualty and Asset Management.

AXA is reasonably well diversified geographically however it does have large operations in France and the rest of Europe and as an insurance company holds significant levels of European government bonds. Notwithstanding this, the company has maintained strong financial performance, improving on its key solvency ratio and beating market consensus at the most recent half year reporting season.

AXA has two Australian dollar Tier 1 securities; one fixed, one floating, each of which has a call date of 26 October 2016. Both issues have a final maturity date of 26 October 2021, however as a major issuer of bonds, we expect AXA to follow protocol and call at the first opportunity in 2016.

At the start of the financial year, as investors began to move towards locking in fixed rate returns, we began to see the “spread” (the return for taking on risk in a fixed income investment) diverge between the fixed and floating issues. This divergence has largely persisted through the second half of 2012 however, with rates now slashed considerably from where they were in June, the gap between fixed and floating looks overdone, offering value to investors prepared to buy the floating rate security.

Fixed or floating?

At current pricing, the AXA floating rate Tier 1 security looks more attractive. It is offering 5.61% over the bank bill swap rate (BBSW). The fixed rate equivalent is offering a margin more than 1% less at only 4.32%. To ‘break-even’ there would need to be five rate cuts (beyond what is already factored in) for the fixed issue to show better value than its floating rate equivalent. With base rates already at 3%, five cuts from here appears’ unlikely.

Offering a yield to call of 8.84% for an investment grade issue, the AXA floating Tier 1 security is offering outstanding value for investors able to get comfortable with AXA’s European focus.

These bonds are not listed on the ASX and can be purchased through a fixed income broker or a private bank.

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

Editor’s note: AXA SA senior debt is rated A by Standard and Poor’s, with a negative outlook. Company credit ratings are generally not provided to retail investors under guidance from ASIC  due to concerns the ratings may be used to influence investment decisions. Please do your due diligence in understanding any investment product in full before choosing to purchase it.

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. Anyone should consider the appropriateness of the information in regards to their circumstances.

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