Taking the plunge on bonds

Corporate bond yields have risen in recent weeks, along with government bond yields after Ben Bernanke made his comment regarding tapering of Quantitative Easing (see Chris Black’s article A turning point in the bond market?). In the meantime, most Australian economists are still anticipating a further rate cut next month. According to Bloomberg, 10 of 16 named economists expect the cash rate to be cut from 2.75% to 2.50% at the RBA board meeting next month. This doesn’t bode well for term deposit rates.

According to data compiled by FIIG, average term deposit rates for  70 authorised deposit-taking institutions across all maturities is a low 3.639% and a further cash rate cut could see that rate decline further. Interestingly, there’s little incentive to invest in term deposits over the longer term with the best rates of around 4% being available for short terms and only a small premium of around 0.20% for extending out to five years. Expectations in this market are quite different to the bond market where we’ve seen increasing returns for investors prepared to invest for longer terms.

The table below compares the 10 year US Treasury yield with the 10 year Commonwealth government bond yield. If we were to overlay the two lines you can see that our market is following the US even though the circumstances in the two markets are quite different.

Basically, if you’re a term deposit investor, there’s little reward for investing long term. I’d stick to short terms, although you then have the “hassle” of reinvesting. I think the risk is high that over the next five years rates will rise and then you’re left holding a relatively poor performing asset or have to pay penalty interest to break the contract. However, the banks and other financial institutions setting term deposit rates perhaps don’t need retail funds and/ or their interpretation of the direction of interest rates differs from bond investors.

The big positive is that we’re now able to show investors a number of bonds with returns over 6% and a handful of bonds with yields over 7%. These are excellent returns given the domestic outlook and are 2% plus over term deposit rates.  The margins between the two haven’t been this wide for a while, so it’s a very good time to take the plunge into bonds.

Below are three tables: The first is a sample retail portfolio that provides an overall yield to maturity of over 6%; the second shows a sample wholesale portfolio with a yield to maturity of 6.65% and the last shows bonds with a running yield and yield to maturity of over 6%.

If income is your focus, you’ll be particularly interested in any of the bonds with a high running yield. Running yield is simply the expected interest income each year and does not take into account the gain or loss based on the purchase price of the bond at maturity. In this way running yield is much more comparable to dividend yield on shares. Dividend yield only provides an indication of income and so, if you want to compare equity investment to bond investment, running yield is more appropriate as it also shows income.

What’s exciting is that we can now show investors bonds with yields over 7%. While the return is high, a 7% compounding rate of return is a key investment hurdle as it means investors double their money in ten years. Two bonds show a yield to maturity of over 7%: the fixed rate Silver Chef bond, and the Sydney Airport 2030 inflation linked bond (assuming inflation is 2.5%, the RBA target mid-point). If you consider a running yield over 7%, we can add another four securities to the list: the fixed rate Mackay Sugar, AXA SA, Stockland and Swiss Re.In conclusion, we’re now witnessing a bit of a disconnect in the market in regard to future interest rate expectations. The anomaly provides an opportunity to construct a bond portfolio with high relative yields despite the low interest rate environment.

Note: All investors are assumed to be retail unless they can prove that they are wholesale. Without going into all the finer detail, a sophisticated investor qualifies as wholesale if they can meet one or more of the following:  A person or entity that has obtained an accountant’s certificate dated no more than two years ago that the client:

(a) Has net assets of at least $2.5 million, or

(b) Has a gross income for each of the last two financial years of at least $250,000; and

•           A person or entity that is controlled by a person or entity that meets the requirements of (a) or (b) above.
•           A person or entity who invests where the purchase price of the product is at least $500,000

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

Elizabeth Moran is director of education and fixed income research at FIIG Securities.

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