Given the prospect that global bond yields will eventually rise from today’s exceptionally low levels, the risk of capital loss may constrain the returns from traditional fixed-rate bonds in coming years. Against this backdrop, wouldn’t it be nice to own a bond that actually benefits from rising interest rates? As this note will demonstrate, such an opportunity is now available with BetaShares’ latest innovative bond fund.
Fixed vs Floating Rates Bonds
It is common to interchange the terms “bond” investing with “fixed-income” investing, largely because traditional bond investment benchmarks contain mainly or even exclusively “fixed-income” bonds. In Australia, for example, most active and passive bond investment funds tend to benchmark themselves against the Bloomberg AusBond Composite Index (BACI), which includes only fixed-rate bonds issued by the Federal and State Governments, as well as from corporations and supra-national entities (like the World Bank).
That said, it should be noted that not all bonds are fixed-rate in nature. As the name implies, fixed-rate bonds offer regular pre-set nominal interest payments over the life of the bond. By contrast, variable or “floating-rate” bonds have their nominal interest payments reset at regular intervals to reflect the prevailing level of market-determined interest rates*.
As a result of the fact that interest payments on floating rate bonds adjust to changes in market interest rates, another important feature of these bonds is that their capital or price return is much less sensitive to increases in the general level of interest rates than fixed-rate bonds – as the former’s market value is largely preserved by having their regular interest payments automatically adjusted upward. By contrast, with fixed nominal interest payments, the market value of fixed-rate bonds tends to be forced down as interest rates rise (and pushed up as interest rates decline) so that their implied yield adjusts to be more in line with market rates available elsewhere.
In this sense, floating-rate bonds have greater nominal interest payment flexibility over time compared to fixed-rate bonds and, as a consequence, lower price or capital volatility. These different features are outlined below in the case of a rising interest rates environment.
Income and capital return consequences from a rise in market interest rates
Illustration only. Of course, in a falling interest rate environment, capital returns from fixed-rate bonds would be lifted while income from floating rate bonds would decline.
Medium-term risk for bond yields is to the upside
As seen in the chart below, long-term interest rates in both the United States and Australia – along with many other parts of the world – have fallen to historically low levels in recent years, due to both declines in inflation, sluggish global economic growth and exceptional monetary stimulus by the world’s central banks in the wake of the global financial crisis.
10-Year Government Bond Yields: January 1962 to May 2017
That said, as I have previously noted here and here, with the global economy continuing to recover from the financial crisis almost a decade ago, the risks to bond yields over the next few years appear to be to the upside.
As and when interest rates eventually rise to more normal levels, this would tend to hurt the returns of fixed-rate bonds and bond funds that track fixed-rate bond indices such as the BACI. Given already low fixed-rate bond yields, moreover, interest income would only provide a partial buffer against any price decline in fixed-rate bonds over the short-term.
The BetaShares Australian Bank Senior Floating Rate Bond ETF (ASX: QPON)
Against this challenging background, the BetaShares Australian Bank Senior Floating Rate Bond ETF (ASX: QPON) has been designed to offer today’s investors a potentially better risk-return alternative within the bond investment space. As the name implies, the Fund invests in some of the largest and most liquid senior floating rate bonds (FRBs) issued by Australian banks*.
The risk return characteristics of the Index that QPON aims to track with those of the BACI are detailed in the table below.
You cannot invest directly in an Index, and total return figures shown do not include QPON’s fees and expenses. QPON’s Yield is variable. Inception date of QPON’s Index is 30 May 2017 and data prior to this date has been simulated and may not be reflective of actual results. Risk Adjusted Return is return divided by volatility. Current yield available at www.betashares.com.au. Past performance whether simulated or actual is not indicative of future performance.
Several features of this table stand out:
Better Historic Risk-Adjusted Returns
For starters, although the historic return of the BACI has been higher in recent years (6.1% vs. 5.2%), this has reflected a boost to fixed-income bond capital values from the decline in market interest rates over this period to very low levels – a feat which, as indicated above, is unlikely to be repeated in coming years. Even with this lower historic return, moreover, QPON’s Index provided better risk-adjusted returns given its considerably lower level of annualised monthly return volatility (0.6% vs 3%).
Better current relevant yield measure
Note, moreover, when considering current return potential, an important distinction needs to be made between “running yield” and “average yield.” Running yield is effectively nominal income payments divided by current bond market prices. Average yield (otherwise known as Yield-to-Maturity), however, also factors in inevitable capital losses over time if a bond’s market value is presently considered above its redeemable or “par” value at maturity. To this extent, average yield is a better long-run measure of return potential from a bond investment than running yield.
In this regard, although the BACI’s running yield at as 31 May was higher (at 3.9% vs. 2.9% for QPON’s Index) this is not a good measure of likely returns over time as it does not allow for the fact that past interest rate declines have pushed the market value of many fixed-income bonds in this Index to above their redeemable (or “par”) value when they mature. Allowing for this fact, the average yield on QPON’s Index as at end May was higher than that for the BACI – at 2.6% vs. 2.2%.
Reduced capital sensitivity to interest rates
Apart from relatively favourable current returns, QPON’s Index has also demonstrated attractive risk features compared to the BACI – especially to the extent we may be entering a rising interest rate environment. As noted above, the monthly volatility of returns has been considerably lower. And even though the average maturity of bonds in QPON’s Index is only two years less than for the BACI (4.2 years versus 5.9 years), its floating interest rate structure means its capital sensitivity to interest rates changes (as measured by effective duration) is considerably lower. Indeed, with an effective duration of only 0.13 years compared to 5 years for the BACI, this implies a 1% increase in the general level of interest rates would reduce the capital value of the QPON Index by 0.13%, compared to a 5% decline for the BACI. This reduced interest rate sensitivity is reflected in the fact that the maximum peak-to-trough total return loss (or drawdown) for QPON’s Index in the last ten years was only 0.8%, compared to 3.6% for the BACI.
Low correlation with equity returns
Of course, to the extent interest rate moves have tended to be positively correlated with equity market moves in recent years (i.e. interest rates have moved counter-cyclically), returns from the BACI have displayed a stronger negative correlation with equity market returns – thereby providing a degree of portfolio diversification. That said, QPON’s Index has also provided an attractive degree of diversification given the correlation of its returns to that of equities has also been reasonably low at only 0.2.
What’s more, the past negative correlation between equities and fixed-rate bond returns may not hold up going forward – especially if we enter an environment in which bond yields rise and equity returns fall – due, say, to a rise in global inflationary pressure and aggressive central bank policy tightening.
All up, the QPON ETF continues the BetaShares tradition of offering Australian investors innovative and intelligent investment solutions to help them meet their financial objectives, which are highly relevant to the prevailing macro-environment.
If you would more like information on QPON and the case for floating-rate bonds, I will be holding a webinar on Thursday, 29 June at 12.30pm (AEST) on the topic, please click here to register.
*To be specific, in the case of senior bank FRBs in which the QPON ETF invests, payments are partly variable and partly fixed. The variable component of their quarterly interest payment is based on the prevailing market-determined interest rate at which banks agree to lend each other funds over the following 30-day time period (known as the 30-day bank bill swap rate, or BBSW). In addition, these bonds also pay a fixed interest-rate margin over BBSW that is fixed at the date of bond issue and reflects the bond’s maturity and the prevailing market assessed “credit risk” associated with each bank.