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Benefits Of FRNs

Matthew Macreadie

In consideration of further rate increases from the RBA, fixed income markets are largely ‘pricing in’ the current rate hike cycle. Whether the market is right or not is another matter and often hard to predict. The market will form a path on forward rates expectations based on the outlook from the RBA, view on local inflationary dynamics, and global central bank activity.

Typically, investors will favour floating rate notes (FRNs) over fixed coupon bonds during a rate hike cycle as the coupon on FRNs ratchets upwards as rates increase. Conversely, fixed coupon bonds decline in value.

As such, if the RBA doesn’t raise rates as fast as the market expects then the returns on FRNs would decrease. However, if the RBA raises rates in line with the market and/or higher even, then FRN returns are improved. With this uncertainty involved, it is worthwhile having a diversified portfolio across FRNs and fixed coupon bonds to act as protection when markets melt down. Either way, the outright yields available to investors right now can help to manage the detraction caused by inflation.

Below we discuss the merits of an FRN by using the Ampol subordinated notes (ALDAU 0 12/09/2080) as an example of high grade, BBB-rated security.

This bond pays a coupon of 3.6% above 3m BBSW and is callable in March 2026. Coupons are paid quarterly – in March, June, September and December respectively. In September 2021 (only 1 year ago), this bond only paid a total coupon of 3.6%. However, the latest coupon (September 2022), has ratcheted upwards to a significant 6.2%. The increase in coupon of around 2.6% from last year is purely a result of 3m BBSW being reset as rates increase.

For an investor, holding this bond results in higher income from their fixed income allocation. Many investors have struggled to be able to drawdown this as an income stream for many years without eating into their capital.

Below is a table of the past coupon resets on the Ampol Subordinated notes (ALDAU 0 12/09/2080) as well as the current Australian Bank Bills Curve.

Past Coupon Resets

Accrual Start Rate
09/09/2022 6.209900
06/09/2022 5.083100
03/09/2022 3.745800
12/09/2021 3.660700
09/09/2021 3.610400
06/09/2021 3.625000
03/09/2021 3.638800
12/09/2020 3.620000

Source: Bloomberg

Australian Bank Bills Curve

Source: Bloomberg

The chart below shows the 30-day cash rate futures curve until the end of 2023. Currently, the market is expecting rates to reach 3.9% by June 2023. In June 2023, a coupon reset with a margin of 3.6% would give a return of 7.5% (3.6%+3.9%). This is a very healthy return for a BBB-rated security in 9 months’ time.

Furthermore, the expected return on the Ampol subordinated notes looks very good into the future. The notes are callable in March 2026 so have an expected life of 3.5 years. The 3- and 4-year bank swap curve is currently sitting at around 3.85% (3.78%-3.93%). So based on a 3.85% bank swap curve and 3.6% margin, this note may earn 7.45% (3.6%+3.85%) into the future. This is commonly referred to as the yield to maturity (YTM) on a security. For context, 1 year ago the 4- and 5-year bank swap curve was between 0.6-0.8%. The notes would have had an expected life of 4.5 years (being 1 year longer in life). Thus, the notes would have had a YTM of 4.3% (3.6%+0.7%) – this is a massive 3% less than the current YTM.

A reminder for investors, the credit risk of Ampol still needs to be assessed and monitored carefully.

With all the focus on the cash rate, many investors do not always realise how much medium and long-term bond rates can move very quickly ahead of short-term rates. Nonetheless, short-term rates have now somewhat caught up creating income opportunities not seen for decades.

Although some investors might shy away from adding fixed coupon bonds given the current rate hike cycle, it’s worth acknowledging they currently provide an opportunistic entry point with many bonds trading at a discount to par. If we see a recessionary scenario play out, then we could see upside on those fixed coupon bonds as the curve should flatten and even invert (all-else-equal). Both in Australian and the US, markets are now pricing in rate cuts to start from the middle to late 2023.

Below is a table of the Australian Dollar Bank Swaps Curve as of 20/09/2022:

Source: Bloomberg

About Matthew Macreadie

Matthew’s current responsibilities include providing credit commentary/views on the bond market and specific credit issuers with the aim of aiding investors to make better risk-return decisions. He is also part of a team of four within the Debt Capital Markets (DCM) team, which provides corporates, financials, property, and infrastructure companies with flexible funding solutions.

Prior to joining Income Asset Management, Matthew spent eight years working as a Senior Credit Portfolio Manager at Aberdeen Standard, where he was responsible for the credit portfolio construction and security selection across a wide range of investment-grade/high-yield, financial and non-financial sectors. Reporting directly to the Head of Australian Fixed Income, he oversaw a team of four and was the team’s ESG specialist.

Matthew has executed 1, 3, and 5-year credit-strategies that have been consistently above benchmark.

Matthew began his career at KPMG working in Auditing and Assurance within the consumer and industrials group and then spent six years at Colonial First State Global Asset Management as a Fixed Income Credit Analyst.

Matthew holds a Masters of Applied Finance degree from Macquarie University and a Bachelor of Commerce degree from UNSW.

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