Bond yields have risen substantially in recent months and Janet Yellen’s recent testimony before the U.S. Congress has all but confirmed short term rates will rise before too long. In past tightening cycles, US long term rates have also risen and, given the high correlation between US bond yields and Australian bond yields, rates will inevitably rise here too.
Which is great if investors hold assets which have a floating rate. Floating rate securities have their periodic interest payments, otherwise known as coupons, reset at quarterly or half-yearly intervals. The coupon is usually calculated by adding a margin to some well-known benchmark rate such as BBSW.
Fixed interest investors, on the other hand, lock in a return for the life of the asset, unless they sell it before the maturity date. In some ways, fixed-interest investors can’t lose*; hold the bond until maturity and the investor has a known, positive income each and every year until the maturity date. In a period of falling yields, this is important because investors can maintain incomes even as interest rates fall all around them.
However, there is always a catch or a price to pay for everything in life and there is a flip side to the certainty which comes from a fixed income security. Investors may end up with a return which will turn out to be on the low side if bond yields rise over an extended period of time, as they seem to be doing now. Even if an investor has no intention of selling prior to maturity, seeing the value of an asset fall as market values change is nobody’s idea of fun.
Shaw and Partners Income Strategies team point out how floating rate securities protect investors from rising yields. The technical name for the risk of rising yields is duration risk and it refers to a bond price’s sensitivity to change in yields. If one were to exclude the effect of accrued interest on the price of a bond, as yields rise, prices fall and the higher a bond’s duration, the greater its sensitivity to yield variations. The team at Shaw & Partners point to the wide range of hybrid securities available on the ASX, saying they “offer significant protection from the duration risk associated with rises in interest rates.”
Investors who wish to avoid the Tier 1 securities such as capital notes and converting preference shares may still do so with ASX-listed Tier 2 securities. These are much closer to traditional bonds and notes and are in many cases issued by financial institutions with solid credit ratings.
*unless they have bought a European or Japanese bond at a negative yield to maturity.