Fixed rates on the rise

PORTFOLIO POINT: High interest rates, and the government guarantee, are increasing the attraction of fixed interest investments.

The excitement of the global sharemarket recovery makes it a good time to pause and consider the structure of your portfolio for the long term, and that means reviewing fixed interest investments. This week I want to isolate some of the forces we are seeing develop in the interest bearing securities market. No one can be certain, but it appears the forces I isolated last week (see We’re in for a bumpy rise) will force the Reserve Bank to lift interest rates about 100 basis points (one percentage point) by mid-2010. Some economists are tipping rises of 125–150 basis points in the next 18 months.

Others believe 75 will do the trick. For the moment let’s assume about 100.

Banks are lifting their deposit rates in response to the 25 basis point hike in official cash rates (to 3.25%) made earlier this month. Should you jump in and lock in the long-term rates on offer? Rates for longer-term deposits are anticipating rises but I think its best to stay short at the moment, until we see just what the Reserve Bank has in store for the economy in November and December.

Most actuaries use a 6.5% return when calculating future earnings, so when bank or corporate bond rate returns go beyond that benchmark level it’s time to consider what proportion of your portfolio you want in interest bearing securities.

But first I’d like to look at what we have learnt about interest bearing security investments during the bad times. Here are five lessons.

1 One of the most popular options for retail investors in Australia are hybrids. But beware of hybrid stock in smaller companies that have difficulty raising money in a crisis. Companies that get into trouble are normally unable to pay their hybrid debt and almost always defer interest. Conversely, those that perform well often exercise their right to repay their hybrids early, so ending the high income streams. Investors miss out on the long-term high income gains and cop the losses. If you are investing in hybrid stock, the best alternatives are the big banks which have clearly shown their ability to raise cash equity in bad times. (You can read more on hybrids here.)

2 Check closely the security that is being offered. Justin McCarthy of FIIG Securities points out that there are potentially seven layers of security. First is government guaranteed bank deposits under $1 million. The second is bank deposits over $1 million that are not government guaranteed. Third is senior debt which is normally ranked first in a company. These three levels of security carry the lowest risk. Then come a series of layers that rank behind the top debt layers. These carry higher risk.

Right at the bottom but ranking above ordinary shares are many hybrids, including the latest Commonwealth Bank PERL issues. Even though the PERL hybrids rank in the sixth layer of securities in McCarthy’s scale, the Commonwealth Bank has enormous capital-raising power and a huge market capitalisation.

PERLS V, offering 3.4% above the 90-day bank bill rate, was rushed and went to a premium in the market. It is currently trading at $205.90. (I must disclose here that our family superannuation fund took up a small holding of PERL stock.)

But we have seen in the UK that when a bank got into deep trouble these low-ranking securities were not treated well by the government in the bank rescues and they went to a substantial discount on the market in tough times.

The real lesson from the crash is that if you are going to invest in low-ranking debt securities, make sure you have a good margin over the base rate and that and the bank or major corporate has strong equity-raising ability. Westpac and AMP fit those criteria. Alternatively, where there is a low margin due to the fact that the issue was made when the risk was not appreciated, the market price must be lower. All of the Big Four – Commonwealth, NAB, Westpac and ANZ – have hybrid securities in this bracket.

3 Back in March, when banks were charging very high rates of interest on corporate loans and the credit markets were very tight, we had expected a large number of corporate bonds to be issued to the retail sector.

There were a large number of bonds issued to the wholesale market, where applications had to be at least $500,000, but the retail sector got bogged down in prospectus requirements. The general belief is that it will take well into 2010 before those requirements are sorted out to enable companies to issue bonds to retail investors without a complex prospectus.

In the meantime, bank margins to top corporate borrowers have declined and there is money available at the top end. Nevertheless, many companies have seen how dangerous it is to be dependent on banks and will tap the retail bond market.

4 We have seen Tabcorp overcome the prospectus problems and make the retail bond issue, with a security that is ranked equally with the banks. The Tabcorp bond (click here) was enthusiastically received and is trading as a premium on the market. McCarthy says a really interesting development is the debt issues that have been put out by the Canadian Brookfield Group operating as a property trust manager in Australia.

Listed property trusts are bemoaning the fact that they can’t get loan capital from banks. Brookfield has shown that banks are not required and has made at least two issues of bonds secured over particular properties, and has been able to get loans of up to 60% of valuation by offering yields of around 8.5% over 3–5 years. At this stage the offers have been relatively small but there is clearly strong demand.

In terms of the options available to some interest bearing security investors, it is really hard to go past government-guaranteed interest bearing securities issued by banks, which have raised deposit interest rates quickly on the back of this month’s 0.25% lift in the official rate.

It is now possible to get a return of above 6.2% on two-year money, and 5.5% is available for one year. If you are prepared to use some of the lesser-known rural banks, the interest rate is even higher Banks are getting very close to 6.5% benchmark level.

In due course vast infrastructure projects being planned for Australia will be pitched at rates to woo retail savings. Meanwhile, the high rates being offered by Australian banks, plus the government guarantee along with the rising Australian dollar is making it easier to raise money offshore.

Normally this would put a lid on local bank deposits but because the Australian government distorted the market charging too high a fee to smaller banks, it forced the smaller banks to chase local deposits, which, in turn, has lifted the deposit rates of the majors substantially. Many will reject bank securities that tie up money for one or two years but the rates are starting to get to levels that are worth consideration as part of your portfolio.