Fixed rate, floating rate and inflation linked bonds uncovered

Fixed rate bond

A fixed rate bond is a security that pays a fixed pre-determined distribution or coupon. The coupon is set at the time of issue and will therefore not change during the life of the bond. The Commonwealth Government, state governments, public and private corporations all issue fixed rate bonds in Australia.

It is important to understand how the prices of fixed rate bonds move in relation to interest rates. These types of bonds have a pre-determined distribution value, therefore any changes in the interest rate can only be reflected in the decline or increase of the price of the bond.

Fixed rate bond prices and interest rates follow a basic inverse relationship, where the price of the bond will rise as interest rates fall and vice versa. Simply put, when the RBA cuts cash rates in a negative growth environment and poorly performing share market, fixed income investors can offset share market losses by investing in fixed rate bonds that perform well in a low or negative growth scenario. Remember, fixed rate bond prices rise as the interest rates (or yields) decline, so investors can achieve capital gains if they sell the bonds prior to maturity.

Floating rate note

A floating rate note or FRN is a security that pays a coupon linked to a variable benchmark. In Australia most FRNs pay a coupon set at a margin above the bank bill swap rate (BBSW) which is the market benchmark rate for the underlying coupon. The actual coupon for an interest period will be determined at the start of the period by applying the coupon margin to the underlying benchmark on the first day of that coupon period, for example, the three month BBSW. It is very common to see the FRN coupon payments quoted as “3M BBSW + 170bps” (bps is short for basis points and 100bps equals 1.0%); “170 over” or “issued at a margin of 170bps”.

The underlying benchmark changes over time based on the prevailing interest rates. Therefore, in contrast to fixed rate bonds, investors would choose to invest in FRNs in a raising interest rate environment, where the coupon payments will reflect changes in interest rates.

Inflation linked bond

Inflation linked bonds or ILBs are fixed income securities that provide a direct hedge against inflation and therefore should feature in most portfolios. Inflation is of particular concern to retirees as it can erode the purchasing power of their capital. In addition ILBs provide the following:

• Diversification benefit, compared to nominal (fixed rate) bonds which reduces the dependence of your portfolio on “growth” assets, like equities
• Consistently high returns in all inflation and growth scenarios

Major issuance in Australia is through the Commonwealth Government and the state government programmes and there are corporate issuers as well. Two major types of ILBs are:

• Capital indexed bonds (CIBs) – indexing occurs quarterly on the principal amount of the bond which is repaid at maturity. The amount of indexation is usually based on the Australian Consumer Price Index (CPI). As inflation rises, the principal value also rises. During periods of deflation, the coupon is paid on a decreasing principal. However, under the terms of Government issued ILBs, the return of the original capital value as a minimum is guaranteed.
• Indexed annuity bonds (IABs) – a stream of principal and interest payments. Unlike CIBs, where the indexed capital amount is paid at maturity as lump sum, IABs have the principal paid off gradually over the life of the bond.

Investors looking for higher income (cash flow) over the life of the bond may consider an IAB as better suited to their needs, whilst investors looking for an inflation protected capital return at maturity may prefer a CIB, which is the most common ILB. However, both ILBs provide direct protection against inflation and no other investment has that same direct relationship, so ILBs also offer diversification for your portfolio.