For most conservative investors either governed explicitly or implicitly by the Trustees Act 1925 and the Prudent Person Guidelines, there are three main strategies for enhancing returns which are:
- to take interest rate risk – deciding to lock in a fixed rate of interest today (this may or may not prove beneficial depending on future interest rates available in the market and how the RBA adjusts the cash rate going forward);
- to take credit risk – accepting a greater risk of default or distress by the issuing entity in return for a higher margin or rate of interest; and
- to take structural risk – deciding the type of investment instrument to use (for many conservative investors either term deposits that offer limited to no liquidity, or fixed and floating rate notes that are tradeable, but are more complex to hold and transact).
The choice of which combination of these strategies to employ has also given rise to another risk which has largely remained dormant until recent times but has been highlighted by the reductions in the cash rate by the RBA in June and July. This risk is re-investment risk in that monies from investments maturing cannot be re-invested at the same interest rate. This risk has manifested itself in three forms in recent months:
- the outright form that 90 day term deposit rates have fallen by around 50bps to 60bps in the last 3 months which produces an immediate reduction in portfolio return of 50bps to 60bps when those investments mature and the monies need to be redeployed;
- a temporary under-performance relative to benchmark for investors with portfolios of shorter duration than their benchmarks as their portfolio running yield has fallen faster than the Bloomberg Bank Bill index; and
- a rapid decline in the average yield on the investment portfolio if it is short dated or largely concentrated in floating rate investments which has fallen rapidly with the reduction in the underlying yield curve and interest rates available from new investments.
The lack of attractive investment opportunities has been caused by a variety of factors, but principally it is the reduction in the cash rate of 50bps and secondarily the flattening of the yield curve meaning absolute rates have fallen by more than 50bps in maturities from 3 months out to 2 years. Tertiarily, credit margins have contracted as ADIs have less demand for funds as they are lending less due to a slowing housing market and investors are looking for additional yield in response to the interest rate reductions, meaning credit margins have contracted due to demand and supply pressures.
Investors most affected by re-investment risk are those most exposed by having shorter average maturity portfolios. These investors are also the ones most exposed going forward if the RBA decides to reduce interest rates again as is our base case scenario. To mitigate against re-investment risk there are two potential strategies.
A conservative strategy is to buy longer dated FRNs essentially locking in attractive credit margins. This is a strategy Amicus has advocated for a long period and clients who have followed our recommendations each month will likely have a high proportion of FRNs in their portfolio. This is a relatively low risk strategy for mitigating re-investment risk because as long as the issuer does not default, the margin on the FRN is essentially locked-in until maturity, and further the investor is not taking any interest rate risk because the FRN coupon resets every 3 months with prevailing market rates.
A more aggressive strategy is to buy longer dated fixed rate bonds or term deposits. This strategy is bolder because interest rates tend to move by greater margins than credit spreads (absent any genuine concerns regarding defaults of specific issuers) and further unlike credit margins that tend to benefit from a “roll down” effect, interest rates can move in either direction with roughly equal probabilities. However, by locking in a fixed rate for the term it completely nullifies any variation in absolute return unlike the FRN strategy.
Which strategy is the best for individual investors depends on how important it is to them to minimise re-investment risk. If their primary focus is on performance against a floating rate benchmark such as the cash rate, BBSW or bank bill index, then there is potentially no need to consider re-investment risk so long as the interest rate duration of their portfolios are close to benchmark.
However, if partial consideration is given to the absolute level of returns or returns relative to an external benchmark such as inflation or a budgeted interest figure, then it is worth considering hedging re-investment risk. The degree of hedging necessary will likely depend on the existing composition of the investment portfolio in that if it is already partially hedged through existing holdings in FRNs and fixed rate bonds, the need for additional hedging may be less than if it is all-in short-term investments. If there is a large existing holding in fixed rate instruments adding FRNs may be the most appropriate risk management strategy and if there is a large existing holding in FRNs adding some fixed rate term deposits or bonds may be appropriate.
Please feel free to call us to discuss your thoughts on hedging re-investment risk in your own portfolio, if you have found the article above thought-provoking.
