If you ask the question of a broker whether it is best to buy and hold or trade the investments within your portfolio, they will always tell you it is best to trade the FRN’s in your portfolio. This is because brokers make money from broking trades and most importantly make no money if you do not trade so their bias will always be to encourage trading over buy and hold. This is one of the reasons investors need independent advisors who do have this conflict of interest.
There are mixed views within the investment advisor community on this question with arguments on both sides. We conduct below a simple economic analysis using representative margins as at November 2018. As an example at the time an investor can buy a 5 year “AA-” rated FRN and enjoy a margin of 87bps for three years and then sell it at 70bps with two years left to maturity (market spread of 65bps + 5bps brokerage) booking a capital profit of 34bps[1] and then all things being equal invest in another 5 year “AA-” rated FRN at a margin of 87bps. This is undoubtedly good business as you are not only enjoying a running yield of 87bps, but booking capital profits as well. However, to compare it fairly with the alternative of a buy and hold strategy where you just get the running yield of 87bps and no capital profit, one must compare portfolios of equal risk as the monies reinvested in a 5 year FRN would be at a greater risk of loss than those in a 2 year FRN from the same issuer had the 2 year FRN not been sold to re-invest the monies in a 5 year FRN.
What this means is that under a buy and hold strategy for the same risk taken you can have a greater proportion of monies invested in FRN’s than if you adopt a trading strategy, meaning your portfolio can have a far higher running yield for the same risk which may offset any capital profits made by selling the FRN’s.
Again using data on trading margins as at November 2018 and S&P’s historical default probabilities as a measure of risk, the two portfolios listed below are of equal risk[2]. However, Portfolio 1 represents a trading portfolio where 5 year “AA-” rated FRN’s are purchased and held for three years until they become 2 year FRN’s and 3 year “BBB” rated FRN’s are purchased and sold after one year. Portfolio 2 is a buy and hold portfolio where the same FRN’s are held to maturity.
Because of the lesser risk of holding 1 and 2 year FRN’s, Portfolio 2 has a greater proportion of FRN’s at 40% vs 28% for Portfolio 1. This means Portfolio 2 enjoys a higher running yield of 83bps vs 77bps on Portfolio 1. This more than offsets the annual capital gains of 5bps on the total portfolio achieved by selling the FRN’s to realise capital profits.
The best economic strategy depends on relative yields. For example, if we use a less aggressive assumption for Term Deposit yields and choose a margin of 60bps over the underlying 3 month BBSW rate for Term Deposit margins, then this lowers the overall yields on both portfolios. However, it lowers the yields more on Portfolio 1 which has the higher proportion in Term Deposits causing the advantage of the buy and hold strategy on Portfolio 2 to further outperform the trading strategy on Portfolio 1.
The general conclusion is the higher the FRN yields relative to Term Deposits, the better a buy and hold strategy for FRN’s is relative to a trading strategy. This is another reason why Amicus generally favours a buy and hold strategy as the current market trend is for lower Term Deposit yields and higher FRN margins.
[1] 17bps * 2 years – a two year FRN with a coupon of 87bps and a trading margin of 70bps would be priced at roughly 100.34 being the capital gain on the FRN because its trading margin is less than its coupon margin.
[2] Based on expected loss in both portfolios of 17bps as assessed from S&P’s historical default statistics for S&P rated corporates carrying the same rating
