With the cash rate potentially nearing its peak and speculation the RBA may cut rates in late 2023 to stimulate a weakening economy, some investors may consider locking in elevated fixed rate yields to secure higher returns. There are several key factors investors should consider before investing in fixed rate investments. We use NTTC bonds as an historical example in our assessment below.
“Benchmark” bonds issued by Northern Territory Treasury Corporation (NTTC) are actively traded and compete with other liquid bonds issued by the six states in Australia (semi-government bonds). NTTC is rated Aa3 by Moody’s because it is explicitly guaranteed by the Northern Territory government which has taxing powers and a level of implicit support from the Federal Government.
As interest rates were very low in mid-2020, NTTC bonds appeared very attractive as they were paying relatively high rates of interest above 1% for all terms when rebates were factored in. However as with all fixed rate investments, the bonds carried risk the underlying interest rate environment would change (i.e. interest rates would rise and investors would be left holding bonds paying below market coupons).
We analyse below how those investors who purchased NTTC bonds back in 2020 have fared over the period of their investment. In September 2020, annual interest rates offered on the NTTC bonds were:
The rates quoted are annual rates to the maturities shown. In addition to interest on the bonds, NTTC paid a 0.25% agency fee to organisations with an AFSL who placed the bonds with their clients. Amicus was able to capture this fee and rebate it to all its clients, thus effectively boosting the yields on their investments. This enhanced the annual yield on the then 15 month December 2021 bond by 20bps (equal to 25bps / 1.25 years), by 11bps (equal to 25bps / 2.25 years) for the December 2022 bond and so forth for the remaining bonds as per the table above.
On a simple interest basis, a client investing in a 15 month NTTC bond to December 2021 would have earned 1.00% interest (0.80% * 1.25 years) plus, if the investment had been placed via Amicus, a rebate of 0.25% of the placement fee for a total return of 1.25% as compared with a cumulative return of 0.32% by investing in rolling 3 month TD’s over the period (comprised of 11bps (0.42% / 4) from the September 2022 TD maturing in December 2020, 5bps from the December 2020 maturing in March 2021 etc as per the table). Clearly, the investment in the NTTC bond was a superior choice looking purely at returns.
Similarly, an investment in the 27 month NTTC bond investment to December 2022 was also more favourable with the coupon of 0.90% exceeding coupons paid on 3 month TD’s for all periods except those offered in June and September 2022. Over the total period, clients would have received 2.03% interest or 2.28% when the rebate is added as compared with 1.56% by investing in TD’s.
Unfortunately with interest rates now much higher it appears as if investing in rolling 3 month TD’s will garner more interest relative to the NTTC bonds for maturities out to December 2023, 2024 and 2025 as per the table. This is due to the rapid rise in interest rates since the RBA started raising the cash rate in May 2022.
The lessons learned from this analysis are:
There is Always Risk: Counterintuitively, the most risk is present in situations where the least risk seems to exist. In September 2020, the yield curve was predicting an average interest rate to December 2025 of just over 0.29% (the swap rate to September 2025). This turned out to be wildly inaccurate with investors who rolled TD’s now likely to gain an annual return of just over 3.00% for the period (a factor of ten difference). Even looking at 7 and 10 year rates in 2020, there was no indication of such dramatic rate rises to come. Further, economists were predicting, and the RBA was stating, there would no interest rate rises until 2024. Had this guidance proved correct, then investments in the NTTC bonds would undoubtedly have yielded greater returns over all the periods, with the only realistic chance of under-performance being in the period until December 2025.
In short, in the space of two and a half years since the investments were made the interest rate outlook has changed dramatically because of unforeseen and unpredictable events (policy responses to the lockdowns to slow the spread of COVID and Russia invading Ukraine which led to rise in energy prices and supply disruptions, etc). Everyone underestimated these risks so prudent investors should always avoid discounting too heavily scenarios they don’t believe are likely to occur (”black swan” events).
The Longer the Term the Higher the Risk: Predicting economic outcomes in the short-term is always much easier than predicting over a longer period. The better performance of the NTTC bonds over the shorter period is testament to this fact. It was far easier to predict interest rates were unlikely to rise in the short term as economies were in deep recession with the pandemic and it was all hands to the wheel to keep households and businesses afloat. Obviously, how the pandemic would play out in the medium term after the crisis, and the aftereffects of the government stimulus were much more difficult to forecast.
Performance may be more Valuable in one Period than Another: Feedback we received from many clients at the time was there was great utility in meeting their budgets. In general, these had been set when interest rates were higher and so many clients were under-performing. The immediate boost given by the greater running yield on the NTTC bonds and the certainty of the cashflows was of potentially of more benefit at the time than the risk of under-performance later.
These same clients are no longer under the same budgetary pressures as interest rates have risen dramatically providing them with ample investment opportunities; for them meeting current budget is not a difficult task. Hence, while over the period the NTTC bonds may have yielded less interest, the benefits of smoother cashflows and meeting or exceeding budgets each year has been a benefit that has out-weighed the likely cumulative lower returns.
Benefits of Diversification: Although Amicus had few fears on the credit-worthiness of the issuer NTTC, Amicus was always cautious of the interest rate risks taking a prudent view that simply because neither we nor the market, nor any leading economists could see little risk did not mean there was little risk. Diversification is the last “free lunch” in finance, and it costs investors nothing (or very little) to diversify their portfolios, but inevitably reduces volatility and provides risk protection (particularly against unforeseen and unpredictable events whose probability is perennial under-estimated as is human nature – “Black Swan” events again).
In summary, constructing a well-diversified portfolio will remain crucial for investors regardless of what happens to interest rates in the upcoming year.
