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Fixed versus floating? It’s all a matter of interest rate timing

by Elizabeth Moran | Jun 24, 2014

Investors in bonds have a vested interest in the direction of interest rates. The way they design their portfolio and vary allocations to the three types of bonds should reflect their changing interest rates views.

One of the common questions I’m asked is about my preference for “fixed or floating”. From 2010 until early this year my preference was for fixed rate bonds. Over that period, the economy has slowed and the Reserve Bank has cut the cash rate to try and stimulate the economy and fixed rate bonds have out-performed.

For example a favoured security has been the Stockland fixed rate bond with a 2020 maturity date. When the bond was first issued it had a $100 face value (the amount that will be repaid to investors) and an 8.25 per cent fixed interest rate. So investors knew they would receive $4.125 each half year in interest income, per $100 invested until maturity. That known, fixed cashflow is very attractive and as interest rates have declined in the last few years, investors have been prepared to pay more for the bond and the price has risen from $100 to around $120, providing a higher than expected return.

However, if interest rates rise, the bond price should fall and if you had that expectation and held this bond, you would then likely choose to sell. Investors would still be willing to buy the bond for that high income stream. New investors in the bond who chose to hold it until maturity would still earn a total return of around 5 per cent.

Early this year, my view changed and I began to suggest clients add floating rate bonds. US tapering of quantitative easing, good Australian economic indicators and a low cash rate were all conducive towards the bottom of the interest rate cycle.  The “icing on the cake” was four attractive floating rate issues from: Westpac, Bendigo and Adelaide Bank, IAG subsidiary IAL and G8 Education.

Instead of interest rates rising, the opposite has occurred and fixed rate US treasury bond yields have contracted further providing higher than expected returns to bondholders.

Trouble in the Middle East and possible rises in the oil price coupled with recent US Fed comments that they will keep interest rates low for at least another year, reinforce my view that interest rates will be lower for longer and that having a preference for fixed rate bonds remains a sound strategy.   

Fixed rate bonds have absolute certainty in terms of the income you will earn over the life of the bond and your total return. The certainty that they provide investors looking for a regular income is invaluable.

The income you earn from floating rate bonds rises as expectations of interest rates also rises, the reverse is also true. Thus these bonds provide less certainty to investors, especially those wanting to establish a defined income.

No one is certain about the direction of interest rates and for that reason I would always suggest you have an allocation to all three types of bonds: fixed, floating and inflation linked.

Two bonds worth investigating are the IAL floating rate bond which has a projected yield to first call in March 2019 of 5.28 per cent and the fixed rate Adani Abbott Point Terminal bond of 5.95 per cent which matures in May 2020. Both are investment grade.

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