The certainty of a maturity date on longer-dated fixed rate bonds

Jessica Rusit

FIIG Securities

As global markets brace for ongoing uncertainty caused by higher inflation and rising interest rates, bonds offer investors certainty through regular coupon payments and the repayment of capital at maturity at a known price. Here we discuss these key benefits offered by longer-dated fixed rate bonds.

Background

With central banks globally chasing down higher inflation through aggressive rate hikes (even Australia’s central bank has joined the pack), equity markets are falling, and bond yields have shifted higher.

While the capital price of longer-dated fixed coupon bonds is lower as a result (although we expect a flight to safety in due course that will see yields tighten), it can be said if an investor is comfortable with a bond’s individual credit quality, then they should also be comfortable looking through capital price movement.

The reason for this is that unlike discretionary dividends paid on shares, the coupon payment on a bond is a contractual agreement that a company must meet. Furthermore, unlike equities, bonds have a specific repayment date when the issuer must repay full principal back to bondholders.

Here we further delve into these key features bonds offer and the certainty they offer investors during periods of capital price weakness. 

Fixed coupon bonds

With rates higher, the capital price on longer-dated fixed rate bonds has fallen. However, longer-dated fixed coupon bonds form a core holding of a portfolio and offer investors a level of protection.

Irrespective of capital price movements, issuers have a legal obligation to meet coupon payments and the repayment of capital at maturity. Failure to do so is considered an event of default.

With this in mind, when selecting longer-dated fixed coupon bonds, we generally prefer investment grade rated exposures and those paying a higher coupon. The higher running yield provides somewhat of a buffer for periods when there can be downward price activity. Alternatively, better returns can be achieved when bonds are purchased at a significant discount to face value, providing opportunistic entry points.

While having the assurance of a maturity date, bonds also provide an investor with the comfort of a known redemption price, whether it be optional calls prior to the final maturity date (sometimes at a premium to face value), and/or a final maturity at par ($100). This means that regardless of where the bond trades over its tenor, an investor is aware of the final capital price they will receive at redemption.

Furthermore, with the concept of time value of money, as the bond’s tenor shortens, the bond’s capital price can improve. When a bond is originally issued, the credit spread paid over the risk-free rate is typically higher the longer the bond has until maturity. This is due to there being more credit risk (risk of default) associated with lending for longer periods, compared to shorter periods of time, and for the optionality of redeploying funds being lost.  

Over the life of the bond, as the length of time to maturity gradually shortens, the credit margin and risk-free rate both decrease (all things being equal) as duration and credit risk are gradually priced out. With this, the bond’s original yield moves lower, causing the bond price to rally.

While a longer-dated bond is more sensitive to interest rate movements, impacting its capital price and making it less appealing to exit at a capital loss, a balanced portfolio with an exposure to shorter dated and floating rate notes will provide better liquidity options during these periods. Floating rate notes, where the coupon is reset each quarter, are less exposed to duration and interest rate risk. 

Case study – Omni Bridgeway

To better demonstrate these key bond features, we will look at the recent early redemption of Omni Bridgeway’s 2026 fixed coupon bond. These bonds paid an attractive 5.65% coupon and were issued in 2019.

The bonds had the option of early call dates, where the issuer could redeem the notes prior to its 2026 final maturity date, but at a premium to par (compensating investors for the early redemption). In 2022, the call price was at $102.00, which then dropped by $0.50 each year until the redemption price reached par ($100) at maturity.

While the bonds had a 7-year tenor (where longer dated fixed coupon bonds can be closer to 10 years or more), they were also unrated, which saw more price sensitivity to credit spread widening.

As the chart below illustrates, the capital price traded at a discount to face value at times, reaching lows around $94 during the height of the COVID-19 pandemic. However, despite any price movements, the notes continued to pay their high coupon at each periodic payment date and still offered investors a known maturity date and redemption value.  

Source: FIIG Securities 

Following this capital price weakness, the notes traded higher over the course of that year and were then redeemed early at $102 in July 2022. This shows the capital price upside (and additional return) a noteholder would have forgone if they were to have exited during the period of price weakness.

It illustrates the importance of looking through any price volatility if an investor is comfortable with the credit quality of the individual exposures, as this does not inhibit the issuer’s ability to make coupon payments or repay the capital at maturity.

Conclusion

With equity markets correcting and bond markets repricing for higher inflation and higher rates ahead, there remains ongoing uncertainty. However, bonds provide investors with some certainty, unlike equities, with an issuer legally obligated to make coupon payments and the repayment of capital at maturity and at a known price. 

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FIIG Securities Limited (‘FIIG’) provides general financial product advice only. As a result, this document, and any information or advice, has been provided by FIIG without considering one or more of your objectives, financial situation and needs. Because of this, you should, before acting on any advice from FIIG, consider the appropriateness of the advice having regard to your objectives, financial situation and needs. If this document, or any advice, relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a product disclosure statement relating to the product and consider the statement before making any decision about whether to acquire the product. Neither FIIG, nor any of its directors, authorised representatives, employees, or agents, make any representation or warranty as to the reliability, accuracy, or completeness, of this document or any advice. Nor do they accept any liability or responsibility arising in any way (including negligence) for errors in, or omissions from, this document or advice. FIIG, its employees and related parties earn fees and revenue from dealing in the securities as principal or otherwise and may have an interest in any securities mentioned in this document. Any reference to credit ratings of companies, entities or financial products must only be relied upon by a ‘wholesale client’ as that term is defined in section 761G of the Corporations Act 2001 (Cth). FIIG strongly recommends that you seek independent accounting, financial, taxation and legal advice, tailored to your specific objectives, financial situation and needs, prior to making any investment decision. FIIG does not provide tax advice and is not a registered tax agent or tax or financial advisor, nor are any of FIIG’s employees or authorised representatives. FIIG does not make a market in the securities or products that may be referred to in this document. A copy of FIIG’s current Financial Services Guide is available at www.fiig.com.au/fsg. An investment in notes, bonds or securities should not be compared to a bank deposit. Notes, bonds and securities have a greater risk of loss of some or all of an investor’s capital when compared to bank deposits. Past performance of any product described in any communication from FIIG is not a reliable indication of future performance. Forecasts contained in this document are predictive in character and based on assumptions, such as a 2.5% p.a. assumed rate of inflation (unless otherwise specified), foreign exchange rates, or forward interest rate curves generally available at the time, and no reliance should be placed on the accuracy of any forecast information. The actual results may differ substantially from the forecasts and are subject to change without further notice. FIIG may quote to you an estimated yield when you purchase a bond. This yield may be calculated by FIIG on either A) a yield to maturity date basis; or B) a yield to early redemption date basis. Some bond issuances include multiple early redemption dates and prices, therefore the realised yield earned by you on the bond may differ from the yield estimated or quoted by FIIG at the time of your purchase. The information in this document is strictly confidential. If you are not the intended recipient of the information contained in this document, you may not disclose or use the information in any way. No liability is accepted for any unauthorised use of the information contained in this document. FIIG is the owner of the copyright material in this document unless otherwise specified.

Jessica Rusit
Associate Director – Investment Strategy Group
FIIG Securities

Jessica Rusit has over 15 years of experience in financial markets, and over 9 years working in fixed income markets. Prior to joining FIIG, Jessica worked in funds management and private wealth management, at Challenger and JBWere, respectively....

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