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The threat of higher interest rates, slower economic growth, rising inflation and deteriorating credit is making investing scary at the moment, especially in equity markets. There are few risk-free places to hide, other than short-dated government securities. However, there are income opportunities not seen for many years. With all the focus on the cash rate, many investors do not realise how much long-term bond rates are already far ahead of short-term rates.

The increases in the bank swap rates in recent months have been dramatic, as shown in the chart below. With the five-year around 4.5% and high-grade securities offered at spreads of say 2% to 2.5% above the bank curve, fixed rate investors can achieve around 6.5% on quality names.

But even for investors willing to place money into bonds to take advantage of better yields, a decision is needed on whether to go fixed or floating.

Let’s clarify some basic terminology.

A fixed rate bond means the coupon or interest rate paid over the life of the bond, say five years, is fixed for the term.

A floating rate bond means the coupon or interest rate varies according to a short-term benchmark, usually the bank bill rate in Australia, even if the term is the same five years. In other words, the rate changes every three months or 20 times over five years.

(Note that fixed interest rates have been moving significantly every day this week and the rates quoted in this article are illustrating specific points and may be out-of-date within a few days).

A recent transaction by Macquarie Bank shows the fixed versus floating opportunities. Macquarie issued a subordinated bond for $850 million and the market was happy with a credit spread of 2.7%. Investors had the opportunity of taking the 2.7% as a margin over the 3-month bank bill rate or as a margin over the five-year swap rate.

This transaction is known as a 10nc5, that is, the final term could be as long as 10 years with a ‘non-call’ period of five years. Issuers are expected to call after five years as they lose the favourable treatment as regulatory capital after year five. Macquarie was indifferent to fixed or floating because large borrowers can enter an interest rate swap to convert the fixed rate to floating or floating to fixed according to balance sheet need. Therefore, Macquarie allowed the market to decide the mix.

Based on demand, Macquarie issued $500 million of fixed rate and $350 million of floating rate. What are the investment opportunities?

Based on the five-year swap rate of 3.35% at the time of pricing and an issue margin of 2.7%, the fixed rate piece offered 6.05% (rates have risen since the deal was priced and it is now available above 6.5%).

For income-starved investors, here is a high-quality bank paying over 6% per annum for five years. Many retirees look to drawdown around 5% a year from superannuation as an income stream and this has been difficult to achieve for many years without depleting capital.

The floater also carries a 2.7% margin. Based on a bank bill rate of say 1.5%, the initial return would be 4.2% (2.7%+1.5%), or significantly less for the first period than on the fixed rate tranche.

The chart below shows the 30-day cash rate futures curve until the end of 2023. At the time of writing, the market is expecting short-term rates to reach 4.4% by May 2023. A rate set with a margin of 2.7% would give a return of 7.1%, which is well ahead of the fixed rate tranche.

And therein lies the challenge.

Anyone who thinks the market is pricing rates too high should go fixed and grab the rate on offer now. Anyone who thinks the market is correct or rates will go higher should go floating.

(Note this bond is available to wholesale investors only but that is a surprisingly large group of investors, as explained here).

Remember that for fixed rate investors, two risks can send prices down: either term interest rates rise or credit spreads widen, so such an investment should be part of a diversified portfolio.

For investors who cannot access wholesale bonds, NAB recently issued a new hybrid (ASX:NABPI) paying 3.15% above the 3-month bank bill rate. Again, based on a bank bill rate of 1.5%, the initial yield will be 4.65% buying at par or $100 (prices will vary when trading on the ASX). This hybrid has an expected life of 7.5 years (hybrid spreads have widened since the date of writing this article. See the Firstlinks Education Centre for weekly price updates from nabtrade).

But if measured against the 4.5% bank swap curve and 3.15% margin, this hybrid may earn 7.65% in future. The return is similar to the franked yield on NAB’s shares without the equity market risk, based on the previous experience that hybrids are significantly less volatile than bank shares at times of market shocks.

Beneath the simple exterior of a floating rate bond, bank hybrids are complicated instruments, including conversion to equity in certain circumstances, but Australian banks are extremely well capitalised.

Retail investors can also consider bond funds, bond ETFs and listed bonds, either in fixed or floating structures, so these opportunities are not restricted to wholesale investors. For a floating exposure, check the fund's fact sheet for a repricing duration of 90 days or less. For fixed rate, the duration is more likely five or more years.

The failure of the Reserve Bank Governor, Philip Lowe, and its Board, to foresee the rampant inflation of 2022 shows that even with the best information in the world, forecasts are a guess. Lowe repeatedly stated until six months ago that cash rates would not increase until 2024, but now the market expects cash rates over 3.5% by the end of 2022.

Former Reserve Bank Governor Ian Macfarlane recently stated that the inflation target of 2% to 3% will be difficult to achieve and is more likely to stay around 5%.

Adding to the uncertainty, despite US inflation hitting a 40-year high of 8.6% last week, Bloomberg writes that “Inflation is poised to ease according to these three indicators”. The three items are falling prices of computer chips, shipping containers and fertilisers, all key input to the manufacturing processes of thousands of companies and products.

Either way, nominal yields available to investors now can make a meaningful contribution to the income required to keep up with inflation, and cash and term deposits paying 1-2% have serious yield competition. Fixed or floating, or a bit of each, bonds are back in the game.

In 2016, fixed interest expert Warren Bird wrote an article called "Are we going through a bond market route?". Here is a follow up with his thoughts on whether fixed rates are value at current levels.

"Over the last two years, since July 2020, US 10-year yields have risen from 0.55% to 3.43%. That's 2.88% over 23 months. We're seeing negative returns over the two-year period for the typical Australian bond fund of 10-15%. It's not necessarily over yet, of course, so the record bear market move in the US of 3.25% in 1987 is well within reach and could easily be exceeded.

The lunacy of central banks ignoring how their QE had turned into money supply growth in 2020-21, resulting in them not acting to contain inflation a year ago when it was obvious that it was going to be an issue, means that even at 3.4%, the US 10 year Treasury bond is paying a big negative real yield at the moment.

But it's not as negative as cash, so I expect that the big end of town will start to nibble at buying bonds and lengthening duration from here. Cautiously, I suspect, but if the central banks do start acting to reign in their monetary policy accommodation and get us back to a more slow and steady with inflation, then from a longer-term perspective, yields are just about at 'fair value' levels."

Graham Hand is Editor-At-Large for Firstlinks. This article is general information and does not consider the circumstances of any investor. Disclosure: Graham has invested in the fixed rate component of the Macquarie transaction and the floating hybrid of NAB, taking a bit each way in his diversified SMSF portfolio.

Hypothetically lets consider if central banks and govts did nothing during the pandemic. With people laid off work and lockdowns, we would have had a depression about 5 minutes. So, was the additional spending actually inflationary (meaning excessive over the economy capacity) or did they just manage to fill a bloody great hole and hold the ship steady? It's not the same as adding $200 billion to a normal economy, it was adding $200 billion to an economy that was about to lose $200 billion of output. Take away Chinas obsession with covid and lockdowns, supply chain issues from covid and a little spat in Europe impacting energy prices and some floods affecting food prices, where would inflation be now? Interest rates had to get somewhere closer to normal. Expecting depositors to accept a pittance for their money was never a long term option.

Well, Steve, I have to say that I reckon in the US it would be around 5-6% without those factors. That's what I had in mind in late 2020 when I first provided my thoughts on what the money supply growth we were seeing was portending. That was before supply chain issues emerged during 2022. Supply chain is a factor, but demand and money supply growth is at least just as significant.

It can do both, of course. filling a hole for years 1 & 2. Inflationary in years 2,3,4...

Thanks for another great article. I learn more on this forum than any other. Fixed or floating? Take two bonds. Fixed rate Equity Trustees Ltd (YTMMQ1) bought today at $100 pays $4.15pa, so 4.15% into the future. Floating note Macquarie Group Ltd Capital Notes 3 (MQGPC) bought today at $100.49 pays a margin of 4% on top of the bank bill swap rate of 1.7%, so 5.7%. However, interest rates are rising so the floating note MQGPC will pay more than 5.7% each time the BBSR rises. The floating note would seem to be a far better investment than the fixed rate when interest rates are rising. As interest rates rise fixed rate bonds prices should decline and floating rate bond prices should rise, reflecting the improving yields of floating over fixed rate bonds. But currently I see fixed and floating note bonds all dropping in price. Floating rate MQGPC has fallen by 6% and fixed rate YTMMQ1 by 13% over the last 12m. It seems both fixed and floating rate bonds are being sold off in the general rush to liquidate shares, so floating note bonds/notes now represent an even better buying opportunity. I have my eye on some which are looking more tempting every day.

Hi AlanB Yes, I am also perplexed by this price fall in floating instruments. Given the market expects rates to rise significantly, (a margin of 4% might take the payment to 8%), why is there not more demand? Elstree, who specialise in hybrids, give this reason: "The drivers this month were expectations of a new hybrid issue (and speculation about a second issue in the near future), some selling from one broker that indicates an investor/allocator moving out of the sector and negative equity markets." While this is not advice, sounds like an opportunity.

The issue is that most floaters have credit risk. When credit spreads get wider (as they have been ) then the floaters will be revalued using a bigger margin over bank bill, which means a lower price. The longer term, the more credit duration risk there is and the larger the price fall. I had this argument on LinkedIn with a provider of private debt fund investments, which are floating rate, when he argued they were "inflation proof". I don't believe they are because as policy is tightened to fight off inflation you tend to get wider spreads. Yes, the coupon interest they pay will go up as the benchmark rate goes up, but there is also a capital hit when credit risk is affected.

Not such an opportunity for small investors!. Locked out of new hybrid capital notes issues, by ASIC ruling that you have to be a "professional"or wholesale investor. Scandalous rorting of the financial system if you ask me!

I guess I'm getting old, but my head spins when I start reading about swap rates. I've yet to figure out why they even exist. What I do know, however, is that a mate asked about NABPI at his local NAB branch and was directed towards a five year term deposit yielding around 2%. Seems the 'retail' end is getting screwed once again.

Not if you buy government bonds on the ASX. They're paying from 3% for 2 years to just over 4% for 10 years. Banks are being very tardy on TD's I agree.

Colin and Graeme, I agree the restriction on access to new hybrid issues is a poor ruling, but if you check our Education Centre, we include a weekly report from nabtrade with nearly all the existing listed hybrids. Available to anyone who can buy shares on the ASX and expected returns to first call over 8% for major bank names. Not advising, just observing. https://www.firstlinks.com.au/uploads/2022/reports/NAB_ASX_Listed_Bond_Hybrid_Rate_Sheet_15_Jun_2022.pdf

“The lunacy of central banks ignoring how their QE had turned into money supply growth in 2020-21, resulting in them not acting to contain inflation a year ago when it was obvious that it was going to be an issue, means that even at 3.4%, the US 10 year Treasury bond is paying a big negative real yield at the moment.” I’m sorry, but there’s no evidence that QE is inflationary. You’re conflating QE with monetary financing, which it is not. The current inflation was not caused by ‘money printing’, it was caused by pandemic related snarls in supply chains and a war.

O, I am most certainly not doing that. I have often written that QE is not "printing money", including in a primer on QE that I wrote for this newsletter many years ago. But QE has the potential to become the source of money supply growth if the banks lend it rather than recycle it back to their central banks After the GFC most of the QE didn't result in money creation. It did help prevent a complete collapse in broad money, but mostly it ended up as large bank deposits at the Fed. That's why predictions of inflation at the time didn't come about - lots of folk predicted it because they confused QE with "money printing". However, what we saw in 2020 with the pandemic-driven QE was that banks did use it to create credit. This was showing demand strength in the economy that meant that QE turned into a significant rise in money supply growth. I said at the end of 2020 in my various professional contexts that inflation would become an issue as there was now "too much money". That's exactly what has happened. It's a myth that it's just supply chain disruptions. Yes, supply chains have been disrupted, but the only way that can turn into inflation is if demand remains strong and people are willing & able to pay the higher prices, or if they have to (e.g. essential food items). Fixing the supply chain issues should be part of the package of policy responses, but the demand side of the demand-supply imbalance has to be addressed too. Government spending (fiscal policy) and interest rates (monetary policy) both need to be tighter. Money supply growth took off in 2020 and we are now seeing the obvious, inevitable inflation consequences. Central Banks should have seen this coming - some of us did, including Prof Tim Congdon in this newsletter in April 2020 and again in a second article in 2021.

Obviously interest rates are going higher. You'd be crazy to buy fixed rate bonds in this environment

CC, the decision you have to make is whether the bond market has already priced in those increases in short term rates. At just over 4% yield, is the Australian government 10 year bond already paying the likely average cash rate over the next 10 years plus a term premium? If so, then why not buy 10 year bonds on a 10 year view? If you don't take a 10 year view on a 10 year bond then good luck to you. You might be right that yields go a bit higher as the cash rate increases, but then again you might be missing out on a chance. I remember how few people bought 10 year bonds in 1995 at 10% because they thought the cash rate might keep going a bit higher. They missed the last great chance to grab long term value in the local bond market because they took a 3 month view on a 10 year asset instead of looking at the longer term. I'm not necessarily convinced that 4% is the right level, but I think it's getting close. And at the very least you have to give it deeper thought than your throwaway comment does!

CC, the point is not whether cash rates go higher from this point, as we know they will. The point is whether fixed rates have already allowed for the coming rises, or indeed, gone too high. This is the opportunity. At some point, they are a buy. I don't think it's crazy to lock in 6% for 10 years on a quality bond as part of your overall portfolio.

Warren, Graham; What about Treasury Inflation Indexed Bonds? My calculations show negative real yields as the market prices are currently larger than the (CPI adjusted) Nominal Value. For some, a few percent over inflation is all that is required.

Dudley, Australian government inflation linked bonds are trading at positive real yields. Longer term securities are at about 2% real yield, according to the RBA's daily data base. Those are the highest real yields since 2014. Align that with the nominal bonds trading just over 4% and you can see that the market is pricing for inflation to average around 2% over the long term. Of course, as long as inflation is above that level an investor is getting regular cash payments that reflect the higher rate of CPI inflation. Not a recommendation to invest in them, but a return of 2% plus inflation from a government security is worth a look, don't you think, for the conservative part of your portfolio?

"Longer term securities are at about 2% real yield, according to the RBA's daily data base.": Here: Indicative Mid Rates of Australian Government Securities – F16 https://www.rba.gov.au/statistics/tables/xls/f16.xls Cell AS883 = 2.020% ( "Treasury Indexed Bond 415 1.00% 21-Feb-2050" ) Would be most grateful if you would show us how that rate is calculated. From https://www.aofm.gov.au/media/651 "CAIN415 1.00%" for 21-Aug-2022: Kt = 109.14, p = 1.75 Pricing formulae here: https://www.aofm.gov.au/securities/treasury-indexed-bonds [ I took a normalising, simplifying, route by assuming maturity payout is 100 (Future Value), and the Present Value is equal to the Market Value / Nominal (CPI adjusted) Value Kt * 100. I used the YIELD spreadsheet function to calculate the yield%. ] "a return of 2% plus inflation from a government security is worth a look, don't you think, for the conservative part of your portfolio?" For me, $1M yielding 2% indexed maturing around 2035 would be useful as 'insurance' for my aged care.

Dudley, your 1st question, 'how is the rate {of 2.02%} calculated?' Well, that doesn't need to be calculated - it's where the bonds have traded in the market. (In Australia we don't tend to trade bonds off their price like in the US, but our fund managers, bond brokers, etc buy and sell based on the yield to maturity. The price then gets calculated from that.) The trick with inflation-linked bond price calculations is that the maturity value is not $100, as is the case with nominal bonds. The maturity value escalates with the inflation rate. So, for example, in the AOFM table that you linked to, if you look at the recently matured CAIN409 (Commonwealth of Australia Indexed bond issue #409). When it matured in February this year it paid investors $119.84 for every $100 of bond 'face value'. This reflected the rise in the CPI over the time between issue and maturity - prices had gone up by 19.84% so the value of the bond had gone up by that much as well. That's how they provide protection against inflation for your capital over the life of the security. Also, the regular interest payment (the ''coupon'') is calculated as a % of the indexed value of the bond, not as a % of the original face value. So the income goes up with inflation as well. The market price relative to that adjusted face value reflects the difference between the coupon yield and the current market yield. So to go back to the CAIN415 you mentioned, it is a bond that doesn't mature until 2050. It currently has an indexed face value of $109.14. It's coupon is only 1%, so it's going to pay holders in August this year an amount of $1.0914 instead of just $1.00. But in the market, it's been trading at 2% real yield. So the market price is much lower than $109.14 because there's another 1% per year of income that has to be provided. That happens through discounting the purchase price so that the capital value can amortise over the next 28 years until it matures. So if you buy that 2050 Treasury Indexed Bond (eg on the ASX) your total return over the next 28 years will be 2% plus inflation. You'll get that through capital protection of the face value being indexed with the CPI, plus a regular cash flow that's 1% per year of the indexed value, plus a non-cash flow component as the bond amortises up from the purchase price to the eventual indexed maturity value in 2050. The market price can fluctuate and may well fall further if the traded real yield increases further. (At 2% it's higher than it has been in ages.) That won't change any of the return contributors to maturity that I summarised above, but if you needed some capital and had to sell the bond before maturity you might incur a capital loss. But I reckon that over the long haul, a real return on a government guaranteed security of 2% isn't too bad.

Many experts expected the Aussie dollar to fall rapidly when US rates rose above Australian rates, but the fall has been modest. What factors are holding it up and what's the outlook?

A range of factors determine interest rates, and the yield curve reflects expectations of the future. Even if interest rates look low, waiting to invest is attempting to outguess the market.

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A fund manager argues it is immoral to deny poor countries access to relatively cheap energy from fossil fuels. Wealthy countries must recognise the transition is a multi-decade challenge and continue to invest.

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With BBB-rated investment grade credit in solid companies offering yields above 5% - a higher yield than what is currently available in most equity markets - there is plenty of opportunities for yield in fixed income.

Barry Lambert’s lessons apply not only to business, but to life and are an insight into the behavioural differences which make founder-led companies a special hunting ground for investors.

As market uncertainty continues, it is more important than ever to have a sound investment process. To help with a long-term focus, it may be useful to have some guidelines to fall back on when the market noise gets too loud.

Over the past decade, we have seen sales of EVs go from a trickle to a steady stream of rapid adoption. We are now on the cusp of rapid expansion and have momentum to move the transport sector towards a path to decarbonization.

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