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Fixed rate bonds pay the bills

by Elizabeth Moran | Nov 03, 2014

Virtually all economists predict the cash rate will be left on hold next Tuesday when the RBA board meets but a growing number are now calling for the next move in rates to be a cut.

One of the concerns about a rate cut is that it could further stimulate the frothy property market. However, there are good alternatives to monetary policy which could be used to restrain the market instead. These include macro prudential controls where the regulator limits borrowing to a group of applicants, or where there are limits to the amount the banks can lend as a proportion of the value of the property such as those in New Zealand.

A rate cut would support a lower Australian dollar, improving the prospects of exporters and the education and tourism sectors.  

The recent annualised, headline inflation rate of 2.3 per cent, down from the previous quarter, somewhat supports the call for a rate cut.

Regardless, mounting evidence supports the call that interest rates will be lower for longer. But the bills of investors still need to be paid and deposit rates at around 3.5 per cent don’t help much.

Fixed rate bonds are one low risk investment that could provide some relief.

While some market commentators have been warning about investing in fixed rate bonds, their absolute certainty of income and return of principal at maturity can outweigh the disadvantages. 

Before I make some suggestions, I’d like to put some balance into the argument.

Fixed rate bond prices do have an inverse relationship with yield meaning that higher interest rates will cause bond prices to move lower. However, future interest rate expectations are already built into the price of fixed rate bonds. If rates are viewed as likely to move higher then bonds will already be cheaper to reflect this. It’s only changes that are higher or lower than expected that will subsequently influence the price.  

If there are negative movements in fixed rate bond prices you can simply hold the bond until maturity when it repays $100 face value and your overall return will be positive.  If you think interest rates will move higher in say three years, then you would seek fixed rate bonds that mature in three or four years to limit that risk.

It is true that the longer the term to maturity of a fixed rate bond, the greater the changes in price when interest rates change. This is known as duration. Investors certainly wouldn’t want to hold a portfolio that is all long dated fixed rate bonds, but including floating rate bonds and holding a range of maturities in the fixed rate part of your portfolio will limit the impact of duration.

It’s no surprise then that the best fixed rate bond returns are in companies that are lower credit quality, or have longer terms until maturity. Fixed rate bonds offered by Adani Abbott Point, Dampier to Bunbury Natural Gas Pipeline and Lend Lease Finance, are similar investment grade quality over similar terms. The standout being the Adani Abbott Point offering 5.95 per cent to maturity, at least a 1 per cent higher return than the other two.

If you are prepared to take on extra risk, the Qantas 2020 bond with a yield to maturity of 6.54 per cent offers stand out value, especially given positive results announced this week.

For those investors seeking minimal risk, Rabobank has a long dated fixed rate bond maturing in ten years, in 2024 that pays 4.55 per cent yield to maturity.

While it might be hard to imagine, interest rates could be cut and investing in fixed rate bonds will provide certainty of income and the possibility of higher bond prices. They have a place in every portfolio. Like all good investment it’s about weighing the risks and returns and working what suits your specific goals.

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