What to expect when you're expecting

An anticipated Christmas US rate rise may buoy local bond investors, but this will be moderated by the actions of the Reserve Bank of Australia.

Summary: While global markets are expecting a rise in US rates in December, local shorter-dated bonds yields are unlikely to respond significantly unless the local Reserve Bank shifts from its current position that it expects to leave the domestic cash rate on hold for quite some time.

Key take-out: Should Australia shift its monetary policy after a US move, investors in Australian floating rate securities will see their income increase with the rate rise.

Key beneficiaries: General investors. Category: Investment bonds.

The market is now betting that official interest rates in the US will rise by the end of the year, after a much anticipated rate hike failed to eventuate last week.

The federal funds (cash) rate has been on hold at near-zero levels since the GFC and a rate hike is fully priced in by early 2016.

Whenever the US Federal Reserve’s Federal Open Market Committee (FOMC) does finally move, it’s worth understanding how the decision will affect Australian bond investors.

Conventional wisdom says that when interest rates go up, bond prices fall, and vice versa. And that is exactly what happened on Friday in the US.

The failure by the FOMC to raise the cash rate saw a relief rally in US bond prices that was the strongest in six weeks. Conversely, share prices tumbled by almost 300 points on the Dow Jones index, as the FOMC signalled that economic conditions in the US are worse than thought.    

The decision not to raise interest rates in the US will inevitably lead to more market volatility, as investors continue to anticipate the first increase in US interest rates in nearly a decade. The next opportunity will come at the end of October but the betting in the market now, is that the FOMC will wait until its mid-December meeting to finally pull the trigger.

Local bond investors wait for a shift in local monetary policy

However, for Australian bond investors the impact of an interest rate increase in the US will be complicated by expectations for monetary policy in Australia. An increase in interest rates in the US should not automatically flow through to Australia, unless we have surrendered our monetary policy to the US by pegging the Australian dollar to the US dollar, as some countries do.

Thus, when the US cash rate does increase, the impact on Australian bond investors will be moderated by the actions of the Reserve Bank. Also, the impact will be determined by the type of bonds held.

Just as the US Federal Reserve is responsible for monetary policy in the US, so is the Reserve Bank in Australia. And both implement monetary policy by changing short-term interest rates rather than long-term rates.

Long-term interest rates reflect long term expectations about economic growth and inflation prospects. An eventual US cash rate rise should be largely priced in to long-term bond yields already.  

Moreover, given expectations of similar levels of economic growth, inflation and interest rates in Australia and the US, long-term bond yields in the two countries have been moving in line for quite some time now. Any divergence from this trend will be driven by or result in, implications for the value of the Australian dollar relative to the US dollar.

Short-term bonds will feel biggest impact

It is shorter-dated bonds that will feel the impact most but with the Reserve Bank having signalled in the minutes of its last board meeting that it expects to leave the domestic cash rate on hold for quite some time, shorter-dated bond yields in Australia should exhibit little response, particularly if the Australian dollar is allowed to absorb the impact of any foreign investor selling.

If however, the Reserve Bank takes the view that the dollar is low enough at around $US0.70, then short-term yields in Australia will have to rise. This will result in capital losses for bond investors holding fixed rate bonds. The impact of the losses will dissipate along the yield curve – the further out along the yield curve, the less impact changes in short-term rates will have, but to the extent that bond yields move, the price impacts can still hurt because of the longer remaining term to maturity over which the price must adjust.

The picture for investors holding floating rate bonds and interest rate securities if interest rates increase, is quite different though. While in the very short term the price of these securities may fall, the price will quickly bounce back by the time of the next rate reset.

With floating rate securities, the coupon paid will move up and down in line with movements in interest rates and thus the price of the securities remains relatively stable. The performance of floating rate securities is the opposite to that of fixed rate securities, where the coupon remains unchanged but the price of the security moves in the opposite direction to market interest rates.

Among the senior ranking and subordinated bonds and hybrid securities listed on the ASX, only four pay fixed coupons, with the remainder all being floating. This is good news for the vast majority of investors in these instruments: their income will increase as interest rates rise.

There may even be an added bonus, although it may take a little longer to be realised. As interest rates increase, the credit margin demanded by the market tends to decrease.

The credit margin is the margin paid over the bank bill rate to determine the coupon paid to investors. As a security’s credit margin is fixed, any reduction in the margin expected by the market will increase the market price of the security.

A fixed credit margin has the same impact on the price of a security as a fixed coupon on the price of a bond.

Philip Bayley is a former director of Standard & Poor's and now works as an independent consultant to debt capital market participants. He also writes on matters concerning debt capital markets and banking for various publications and is associated with Australia Ratings.

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