They're bonds ... floating bonds

Glenn Freeman

Livewire Markets

Yes, there’s a new Bond in town, the latest blockbuster of the 007 film franchise hitting screens in the US a few days ago. But in the world of finance, it’s a different kind of bond that many investors are currently chasing.

We recently asked Simon Mullumby, who heads up the Australian cash and bonds business at State Street Global Advisors, where he sees the most appeal within the credit space – and why. Getting back to basics, he delves into some of the detail about what these assets are, the range of income they typically deliver, and some of the risks.

A good yield is hard to find

If you’re an investor nearing retirement, have already banked your last pay cheque – or have a conservative approach for other reasons – finding a decent yield without ratcheting up risk has been tough in recent years.

At a time when the real returns on cash are, at best, flat and government bond yields remain low – despite the Aussie 10-year showing positive signs in recent days – you might think equities are the only game in town. But you’d be wrong, argues Mullumby.

The debate rages on over whether the rising inflation seen since developed market central banks began tapering record levels of stimulus is short-lived or something more structural. But it’s almost universally accepted that around the world, official interest rates must lift at some point – and sooner rather than later, many commentators argue.

Rising rates are bad news for a big chunk of the credit market – this is when the “fixed” in the term “fixed income” hurts rather than helps demand as government bond prices fall. That's because most bonds pay a fixed interest rate that becomes more attractive if interest rates fall, in turn lifting demand and the price of the bond.

And of course, the reverse is also true. If rates fall, investors no longer prefer the lower fixed interest rate, which in turn drives bond prices down.

The best of both worlds

What if you want the best of both worlds – an investment that will provide a steady yield but without the volatility or downside risk of stocks? In the current environment, the least “fixed” part of the fixed income market is where you want to be, says Mullumby. And the clue is in the name – floating-rate notes (FRNs).

“They’re bonds but the coupon resets every three months – that’s why they’re called “floating,” Mullumby explained during a recent Livewire interview.
Floaters allow you to position defensively and to be prepared in case there is a selloff in yields. They’re a liquid investment that delivers a coupon every month and are a good fit for any portfolio that needs monthly income and daily liquidity.”

The fact that the coupon (interest payment) of FRNs vary is a key distinction of these credit assets versus other types of bonds. Most bonds carry a fixed coupon interest rate. This means the coupon interest rate doesn’t change, from the time the bond is issued through to its maturity.

For example, government bonds – debt securities issued by the Australian Government – with a 5% coupon interest rate will pay investors $5 a year for every $100 face value amount in coupon interest payments.

But in FRNs, this coupon interest rate is variable, or ‘floating’ – which means it tracks short-term interest rates.

What income do floaters yield?

Investors with cash parked in the State Street Floating Rate Fund can expect a coupon of about 60 basis points above the BBSW, said Mullumby. “Given we’re in a cash environment that’s near zero, generating an average coupon of 60 is very palatable for many of our investors,” he said, while emphasising that as an average, this yield figure is lower for some of the 40 credit assets held by the portfolio, and higher for others.

Consisting almost entirely of banks, the fund holds each of Australia’s “big 4” alongside some of the most recognisable offshore financial institutions including Lloyds (Britain), Banco Santander (Spain), Svenska Handelsbanken (Sweden) and Bank of Tokyo (Japan).

Why only banks?

The overwhelming appeal of banks for this fund is largely due to their credit ratings. Whilst the fund only holds senior unsecured banks, the FRN universe exposure isn’t limited to assets that are only investment grade. Some FRNs are sub-investment grade, for example, lower rated tranches of certain mortgage-backed securities.

“But these are the senior, unsecured credit assets that sit at the top of the list. The higher the credit quality in that banking space, the more liquidity you get,” said Mullumby.

“When running a portfolio like this, liquidity is always at the fore. You don’t want to buy FRNs that are ‘buy-and-hold until maturity’ or where there is extension risk (the danger that issuers will defer prepayments due to market conditions).”

“Demand is huge”

Australian investor demand for FRNs is currently quite high, explained Mullumby – having remained strong even while the Reserve Bank of Australia’s term funding facility was in place.

“But since that was shut by the RBA in July there have been both domestic and international issuers in the market and demand is enormous,” he said. Institutional investors in the space have been lucky to get between 25% or 30% of the FRN exposures they would like.

Local banks are seeing the highest demand, with many local fund managers not dipping into offshore bank issuance. This is an opportunity Mullumby and his team have embraced, with a large team of analysts based primarily in Boston, US and London, UK and big footprints in foreign developed market banks, particularly in Europe and Japan.

What are the risks?

Of course, a focus on FRNs brings some element of risk versus having a broader focus on the more “fixed” fixed income assets.

“You’re subscribing to a portfolio construction belief that at some point, there is going to be an increase in interest rates, that there is going to be inflation,” said Mullumby.
“If we don’t see that for the next five years, there are fixed income investments that will generate more yield.”

But he believes the odds are in his team’s favour, given where bond portfolios and their durations are now. “You’ve doubled your risk over the last decade,” Mullumby said, pointing out the Bloomberg Composite Bond Index is currently running duration of six years versus three years in 2011.

“If you don’t see a pickup in inflation or a BBSW curve that’s selling off and starting to price monetary policy tightening, then fixed investments could work well for you. But if you do believe the RBA is going to increase interest rates – which is what they’re telling us – then we believe FRNs are a good defensive option.”

Learn more

Simon actively seeks to invest in interest-bearing investments of high credit quality, rather than investing in a predetermined basket of securities such as an index. For further information on the Floating Rate Fund, please visit the fund profile below, or the State Street website

Managed Fund
State Street Floating Rate Fund
Global Fixed Income

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Content Editor
Livewire Markets

Glenn Freeman is a content editor at Livewire Markets. He has around 10 years’ experience in financial services writing and editing, most recently with Morningstar Australia. Glenn’s journalistic experience also spans broader areas of business...

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