Interest rates explained
|
Term |
Explanation |
| Cash rate | The ‘headline’ rate that you hear about in the media is the cash rate which is the interest rate which financial institutions pay to borrow or charge to lend funds in the money market on an overnight basis. The Reserve Bank of Australia (RBA) sets this rate and considers changing the rate each month (except January) and from 1990 to 2010 there have been only two years (1995 and 2004) in which the cash rate did not change. Changes in the cash rate impact on market interest rates. You can see the movements in the cash rate here. |
| Bank bill swap rate | The 90-day Bank Bill Swap Rate or BBSW is the benchmark for market interest rates for floating rate products. It is the rate at which banks will lend to each other. This is higher than the cash rate, the exact difference (or spread) can change constantly, reflecting market mood. If the market is nervous then the BBSW rate may be considerably higher than the cash rate, while if there is market confidence then the two rates are close. |
| Fixed or floating rate | Some investments are fixed rate and some are ‘floating’ rate. Both have a face value which is the amount paid to the issuer and that will be repaid on maturity. An investment quotes the rate it is going to pay and pays that annually based on the face value although actual payments you receive might be quarterly, half yearly or annually. With a fixed rate, that is it, whereas a floating rate will change for the next payment period typically based on the BBSW. So you might see a floating rate quoted as, for example, BBSW plus 1.75%. |
Bonds explained
A bond has a face value, which is the amount you get back at maturity, and a coupon amount, which is the interest you get each year and which may be paid at intervals e.g. half-yearly or quarterly. So if you buy a bond at the start of the term, hold it to maturity and get paid the coupon, this resembles a term deposit. If you buy or sell at some other point on a secondary market, this leads to the interesting question as to what a bond is worth at a given point in time. If interest rates on the bond are fixed and are higher than those currently, what happens to the price of the bond? Explore this bond pricing example further to get an idea of how bonds work.| Let’s suppose the current cash rate is 4.75%. If a $1,000 government bond has a fixed interest rate of 5.75% because it originated when interest rates were higher, what is that bond worth? In other words, what amount at 5.75% pays the same interest as $1,000 at 4.75%. It is worth more than $1,000, maybe even up to $1,210 which yields $47.50 (at as rate of 5.75%). So as yields go down, bond prices go up and vice versa. However, if you hold the bond until maturity, you will only receive the face value regardless as to what you paid. So, if the bond is very close to maturity, its value is going to be very close to face value regardless as to interest rate differences. If maturity is a very long way in the future, its value is mainly dictated by the interest rate difference. Therefore, you need to annualise the capital difference between the face value and the price to take due regard of this component. The further away the redemption date is (and some securities are effectively perpetual), the more that interest rate changes affect the price. If you buy a fixed interest security and interest rates fall, then the value of the security will increase. Conversely, if general interest rates increase, then the value of that investment will be marked down. However, if you have a floating rate security, then the capital value should be unaffected by interest rate movements although, of course, the interest you receive changes. Calculating the value of a bond is all about valuing a series of cash flows and must take into account the time value of money. i.e. dollars received today are worth more to you than dollars received in a year’s time and even more than dollars received in two years because you can invest the money received and earn extra interest. You may see investments offered at a certain price with three yields quoted; the coupon or yield on the face value, yield which is the return on the quoted price and yield to maturity which takes into account capital differences. The actual calculation is also affected by how frequently you are paid interest. The price of a bond is also affected by how close it is to making the next interest payment. |
Risks
Before looking at the different types of investments it is worth making a few general points about interest rate securities. In particular, the interest that each product offers is different and there are good reasons for this. Lending to anybody else entails a risk that you will not receive the promised interest payments or that you might not get your capital repaid when it is due. You (and every other lender) want a higher rate of interest to make up for these risks and it would also be very comforting if you had some security, that is a legal charge over some specific asset of the borrower so that in case of default, that asset can be sold and you are repaid. So, when researching a possible investment, you need to look at both the general creditworthiness of the issuer and where this investment stands in the case of serious problems such as liquidation. FIIG Securities Limited has produced this risk versus reward diagram that can be very useful to investors. Typically any interest rate security ranks behind secured credit such as bank loans and is not secured against specific assets although they do rank ahead of normal shareholders.Debenture risk
In Australia, from 1 July 2011, ASIC requires that if someone issues something they call a ‘Debenture’, it must offer security over some tangible property of the issuer and must be fixed rate. But beware of offerings made before that date which may be called, for example, ‘Debenture Stock’ as these may well be unsecured deposits.
Listed investment risk
If you are buying a listed investment and you don’t intend holding to maturity, there is a risk that markets may be illiquid or that the price of the security falls to below what you paid. If interest rates change then then the listed security may trade above or below the face value. Also, as the date approaches when an interest payment will be made, the price should appreciate to take account of the forthcoming payment. Listed prices can fall drastically, even down to zero if the market believes the chance of default is high. Some securities are not repaid in cash but by conversion into the companies ordinary shares and thus may be exposed to risks in the movement of the share price.
The general rule of thumb when it comes to risk is that the higher the interest rate on offer, the riskier the product.Credit rating
You will often see a rating such as A+ against a particular security which is a guide as to the credit worthiness of the issuer. These ratings are assigned by private rating services such as Standard & Poor’s, Moody’s and Fitch. They are expressed as letters ranging from ‘AAA’, which is the highest grade, to ‘C’ , which is the lowest of the grades assigned when a bond is issued. Different rating services use the same letter grades, but use various combinations of upper and lower case letters together with plus or minus. Very roughly:| A | High credit-quality investment grade |
| B | Medium credit-quality investment grade |
| C | Low credit-quality – non-investment grade |
| D | Bonds in default for non-payment |
How to invest
Most bonds are traded over the counter (OTC) which means you need to go through a specialist broker such as FIIG Securities. Unlisted bonds can’t be split and have relatively large face values, the smallest is $50,000 and more typically is $500,000 so it is hard to diversify properly. If you intend to invest in bonds then you should want diversification just as you do with shares, so you would look for bonds with different maturities from different issuers.Bond managed funds
You may decide that you would like exposure to this general class of asset but cannot put together your own portfolio, so you might want to consider a specialist managed fund. There are quite a few offering investments in bonds and you can choose whether to invest in Australian Bonds, International Bonds or a mixture of both.
Some managed funds are ‘plain vanilla’ and invest primarily in very safe bonds and do not use any borrowing. But the downside of this is relatively low yields except in periods of falling interest rates when bond prices appreciate. This has been the case for the last few years, so some of the returns over three years on these funds look very appealing. For example, at time of writing, a PIMCO Global bond fund has a quoted 11.18% annual return for three years but this is not set to continue and may well drop sharply if interest rates rise.
You should be very careful in chasing additional returns in ‘high yield’ funds. Some high yield funds use leverage and invest in securities which are below investment grade and in derivatives such collateralised debt obligations (CDO) which are exactly the type of security which was at the heart of the global financial crisis.
Most managed funds are ‘open’ and accept new investments. Equally, they allow investors to redeem their investments as they please. If there are problems and large amounts are being withdrawn quickly this can lead to the fund having to sell investments at precisely the wrong time. An alternative is a ‘closed’ fund which raises initial money from investors and invests that, returning interest on a regular basis and capital as per the initial prospectus. Such a fund might itself be listed on the ASX in a similar way to Listed Investment Companies (LICs). Examples might be the five series of Australian Masters Corporate Bond funds from Dixon Advisory (AKS, AKT, AKU, AKX and AKY) and the Hastings High Yield Fund (HHY).
At the time of writing, there aren’t any bond exchange traded funds (ETFs) in Australia although these exist on overseas markets and no doubt will be launched here fairly soon.
Investing directly
Government bonds
You can invest directly in bonds from the federal government and from various state governments. If you are considering buying government bonds, visit the RBA’s information site or for some more general information on bonds visit the new Moneysmart site.
If an Australian government bond is the closest thing to a risk free investment, then it is instructive to look at the interest rates on offer as these are the benchmark for all other fixed interest investments. The government offers two styles of fixed interest bonds to retail investors and you can purchase bonds from the Federal Government and various State Governments. Explore this topic in further detail on our Government Bonds page.
Listed investments
You can invest in listed interest bearing securities directly on the ASX as you would shares.
Explore this topic in further detail on our Corporate Investments page
Further information The ASX has an interest rate securities course with 7 topics that you may want to consider if you are intending to invest in interest rate securities. Infochoice have a comparison page for Debentures and it includes Bonds and some Debenture stock that we talked about earlier under risk. The ASIC Moneysmart site is a good resource for further information.