 Hello, thank you for joining this recording of the Floating Rate Notes webinar. My name is Elizabeth Moran, I'm Director of Education and Research at FIG, and today I have with me Lee Winton, who is Head of Portfolio Strategies. Now this webinar is really meant to be listened to after the fixed rate bond webinar. So they're really meant to be listened together, but this is number two. So if you haven't yet listened to the fixed rate bond webinar, please go back and do so if you would like. Now, delighted to introduce you to Lee, and you may have already heard of his background in the prior webinar, but he does have over 30 years experience in financial markets across fixed income, foreign exchange, derivatives and interest rate products. Welcome, Lee. Thanks for joining us. Thanks, Liz. It's great to be here. So, let's get underway. Here's the first slide, which is actually our disclaimer. In essence, the disclaimer says that we can only give you general advice, not personal advice. So if you decide to come to FIG and would like us to help you with a portfolio, we will give you all the research and education and we'll make suggestions. Lee's team will make suggestions about a possible portfolio for you, but in no way are you obliged to accept all of our suggestions. So that if you don't like one of the companies that we suggest, you can say, well, can we find another one? I don't like that company for whatever reason. So, which is one of actually the great things about bonds and investing direct in that you have that choice and that control, but just keep in mind today that we can only provide general advice. Thanks, Liz, and that's so true. It's so great that in my team in portfolio strategy, we're incredibly lucky and we get to work with end clients and their advisors if necessary, and understanding people's needs in terms of yields, maturity and other criteria, we're able to brainstorm and come up with a suitable portfolio. There's sometimes a bit of two-ing and fro-ing between us until everyone's happy and then we go ahead and implement and execute a portfolio. But that's exactly right. That's the aim so that our clients are happy with their investments. Absolutely. It's a great job and it's really interesting to try and get involved in the analysis of different companies and different organizations and different products that are in them. So today, I'm honoured to chat about floating rate notes and as a reminder there are three main types of bonds that we get involved in. There are the fixed rate bonds which pay constant amount of interest at every period. There's inflation products where the interest or coupons are linked to inflation and typically in Australia that's CPI, the consumer price index that changes quarterly. And the third step we're going to deal with today are the floating rate notes. And the floating rate notes are, I often think, simple for people to understand because most of us have mortgages and we're familiar with this concept of that the amount of money, the amount of dollars we pay every month will depend on the interest rate and that interest rate changes as and when the Reserve Bank of Australia, the RBA, alters the cash rate. And there are many debates as to whether banks fully pass that on or otherwise but we're comfortable with this concept of that the amount of interest that gets paid is dependent and is variable on a changing interest rate. And in essence that's exactly what a floating rate note does. Instead of the cash rate which is what a mortgage is priced off, our instruments price off an underlying index that is referred to and known as the BBSW. It stands for the bank bill swap rate and it is published every day at about 10 past 10 and is available on price providers like Bloomberg and it is provided for many periods, the most popular ones of the 1, 2, 3, 6 and 12 month periods and historically it was always used as establishing a method for companies to borrow money at and therefore remembering that as investors we are lending money to companies so those companies are borrowing money it becomes a really good tool and index to base our products off. So the features of the floating rate notes are this underlying index BBSW which is closely related to and linked to the RBA cash rate but is not exactly the same. Plus there is a credit margin which is expressed as a spread and I used to struggle with this concept of credit margin and then back in my early days I had to do credit applications and involved looking at people's income and assets and giving them a credit score and I realized that not everybody was the same credit risk and it is exactly the same with companies that some companies are stronger or weaker than others and therefore some have to pay more or less for their funding and so this credit margin is just like an expression of how much spread an organization has to pay. Then we have the actual mechanism and feature of how the coupons calculated and this is called the day count and often the annual basis. This just depends on what is the frequency of the payment and how the payment might be and then you've got the pricing and it's convention as to whether that bond is trading above or below par and par is typically referred to as $100. Most bonds are issued at $100 but their price moves up and down and that will be both a reflection of how the underlying organization that credit is trading and how the credit spreads in general are trading. With fixed rate bonds, interest rates also have a component but with floating rate notes it's basically organization and credit spreads in general. So rate notes, they pay interest that's based on the level of the underlying benchmark and that just means where is this BBSW rate and typically this rate has recently been the same or higher than the cash rate. The current cash rate is 1.75% and the BBSW rate has been trading at a premium to that in trading at around 2%. So the components of the interest rate are looking at this BBSW rate and adding to it the specific credit margin or credit spreads that's applied to the specific security and that is known at the outset when the company goes and originates and issues and distributes a particular piece of paper, a particular bond. And that credit margin is fixed isn't it Leigh? That doesn't move even though the benchmark moves the margins fixed. Absolutely and I only don't like the word fixed because we use fixed in the context of fixed rate bonds so I tend to say that it's constant. I often use these words like sort of constant and it continually gets applied to whatever the BBSW rate is. Well that's nice because I haven't used constant, I use fixed because then you know that there's a portion that you will always be able to count on no matter what happens to the underlying benchmark. Absolutely. So it's good and we use a lot of these sort of terms technically and it's good to sort of chat and they often have the same meaning. They do. Good. Okay so I thought let's look at an example bond and I thought I might look at AII because when I first came to Australia I'm one of the very first adverts I saw was for that Amy insurance company and that Amy has been going with the same frequency of advert since I first came to Australia which was in 1990 and this AAI group that is basically SunCorp that has some really popular brands like Amy, GIO, SunCorp, FIRO and APIA is really well known. So this is a household name. I thought let's look at one of their securities. So they have a long dated callable security. Its official maturity date is August 2014 but it's callable after five years in November 2020. So it was issued in November 2015 and it has a callable date of November 2020. And generally with these callable bonds, Leigh, we would actually expect the company to repay at first call. Absolutely. So that's really the expected maturity date that November 2020 for this bond. Absolutely. And for all our bonds within FIG as you know we have fact sheets and investors can download them and have a look at them and see under what circumstances might the note not get called but to all intents and purposes it's the intention and purpose both for the organisation that's the borrower and for investors that the notes will get called. So this particular note at the time of issue was released with interest calculated at the three month BBSW rate plus a margin of 3.30%. So that if the BBSW rate is at 2%, then we add that 3.30 to make a total rate of 5.30 and it means for that quarterly period you'll be getting a coupon interest rate of 5.30%. And we look at the number of days in that quarterly period and that can alter. It could be typically 90 or 91 or 92 days or it depends if there's a weekend or holiday as to exactly how many days it is and we actually calculate the amount that you own times that rate for example 5.30% times the exact number of days in the period over 365 which is the annual number of days in Australian interest year. So this bond has got a quarterly coupon payment frequency. It was issued for 225 million. That's a fixed discrete known amount that is released at a time of issue. There's never any more and never any less under normal circumstances. Sometimes there can be situations when the bonds could be partially repurchased and might decrease the amount of an issue at certain purposes. There's 225 million on issue. It was released and issued on the 18th of November 2015 and it will maintain those conditions and at the end of the three month period the BBSW rate will be re-observed and again it will have that margin of 3.30% applied and the same on ongoing basis. Fantastic. Let's look a little bit at this three month BBSW rate. So I've here got a graph which you can look at and the first easiest one to look at is the yellow line which shows the RBA cash rate which is one and three quarters and it's expected to be one and three quarters going forward. We know it will change and circumstances will mean that rates will go up or down but we can also look at where it's projected to be in time. We can use things like futures rates, futures contracts to imply where that BBSW rates might be and futures contracts are very liquid and are very easy to use and observe. The only point to remember is that they are actually not expressed in yields they're expressed in price so they often have price of things like 9800 and to find out the implied yield used to 100 minus the price so 100 minus 98 is 2% and so 2% would be the associated yield with the price of 98 and similarly if the price was 97 that refers to 97.00 that would be a 3% rate and 99 would be a rate of 1% and we believe that the reason for having that relationship is that these contracts are traded on exchanges and the Americans decided that it would be much easier if they could buy and sell and know if they bought something at 98 and sold it at 98.10 that would have made a profit of 10 points whereas if you used yields it would be the reverse they thought it would be too confusing so that's my financial futures background coming to the fore but anyway we can look and see how these rates are illustrated to be but largely their reflection of what policy is going to be whether the RBI has an easing bias or a tightening bias but we know that one of the great things about these floating rate notes is that you're not really exposed to interest rate risk as interest rates move up and down your rates will get readjusted in line with it so for the last 6 or 9 months we have used a very small allocation of floating rate notes in most of our portfolios because we've felt that interest rates have been steady to going down and that's been the scenario of lower interest rates and lower inflation and so because clients have wanted certainty of income we've been using a much larger proportion of fixed rate bonds in our portfolio however it's really tiny we're doing this presentation now because as we enter into the second half of 2016 we would expect that at some point inflation will start to rebound to be at or above 2% again that will stop the lowering of interest rates that we've seen and therefore we will start to endorse more floating rate products in our portfolios It's funny you say that because I look at this graph I'm looking at the pale blue line which is the BBSW forward expectations of BBSW so you can see on the X axis June 16 it's just above 1.9% it dips June 17 it goes down not too much then there's a bit of a slight upward slight downwards and if you look out over 5 years the line it's actually really flat and it just sits above 2.1 it doesn't quite get to 2.1% over out to 5 years so it's actually very flat what we would say yield curve so lots of yields put together make a yield curve and being very flat really implies it's actually you wouldn't necessarily favor one or over the other at the moment you could buy fixed or you could buy floating but it just depends on you as an individual investor wanting to have absolute certainty of income which you do with fixed rate whereas the floating rate ones will move around a little I'm just going to talk for a little bit leave you don't mind the dark blue line at the top at the 2.5% going across is the RBA target inflation rate the midpoint of their target inflation rate so you can see how much lower the current cash rate and the yield curve are than the inflation rate inflation is quite low at the moment but that also would theoretically give rise to RBA thinking about further rate cuts absolutely and the RBA's had a target of 2% to 3% it served it really well and it's been a really good initiative that's set monetary policy around that and that's actually why interest rates are typically much easier to predicts rather than currencies because central banks use interest rates specifically in their ability to target inflation whereas it's much harder for foreign currencies what I would say around inflation is inflation is low now that's absolutely true and there has been some talk that maybe when Stevens is replaced by low in the next few months that low might have a slightly different view and may look to de-emphasize the 2% to 3% target but there have been a number of former treasurers including Costello and actually Keating has come out as well and so this target served it really well and what I believe is that inflation is one of these things that sneaks up on us and what could cause higher inflation is not absolutely certain but there are a number of things that could easily force it to occur and there are things like that were in any way to get an increase in GST if we are in any time going to get some increase in either land taxes or council taxes and there can even be things like a weakening exchange rate because Australia has generally been really poor at reducing its imports when prices go up and the price of those imports go up in Australian dollar terms when the exchange rate goes down we could just see the exchange rates go down to the mid-60s they'll have an immediate sort of pickup on inflation so with inflation you're never quite sure what it is but it comes and suddenly it just grows Very true and one of the key inputs has in the past been oil prices you get a big spike in oil prices and of course just to distribute goods they have to go on a truck or be transported and the cost of fuel so really feeds into many things like fuel oil prices coming way off so anyway just a few things to talk about we're digressing a little bit here Fantastic For the last point I was going to make is that bonds often replace bank vets and borrowers when they borrow from banks typically have their debt priced against BDSW and so borrowers are very keen it makes sense for them to use the same benchmark for their bank loans as for their corporate bonds I think that's a great point I'm going to make one last point on this slide because we've talked a lot about the timing and inflation and expectations and this webinar is meant to be educational so we're using this point in time and today is the 23rd of June 2016 so this graph of BDSW was taken as of today and it changes daily but as of today this is what it looks like so let's move on Perfect So let's talk about the credit spread a little bit more it's also known as the margin over the benchmark rate and as I said it's a reflection of where corporations can borrow money and we know that not everyone's equal some people, some corporations, some governments can borrow money at lower rates than other people and the central bank the RBA or the sovereign the country of Australia would be the strongest borrower in Australia and they are the AAA type borrowers that we hear about and then below then we have groups like the semi-governments the Queensland state and the WA state and then as we move down you have the borrowers who are a single A and double A and we have a scenario where people are able to be judged as what their credit spread is going to be Yes, so that's the credit rating agency's moodies and standard and pours and Lee was referring to standard and pours to credit rating so credit ratings really matter in markets because it's a perception of risk and if you attain a certain credit rating in essence then there's a certain amount to borrow but the higher the rating the scale the lower it costs you so credit ratings are quite important although we don't really discuss the length here No and my only caveat is like credit ratings are just like annual reports and accounts they're only good at a couple of points in time per year and as best as we actually want to know and understand the organisations for ourselves as much as possible just a guide just a guide exactly so here we're looking more at that credit spread and in Australia most professional investors most big fund managers they are measured on some floating rate mechanism it could be against the cash rate it could be against BBSW or it could be against an equity index and that's why floating rate product makes a lot of sense for them in that they can see exactly what is the credit spread number of basis points that they are receiving and decide if they think the investment is reasonable or not Historically banks were able to borrow at the index level at BBSW with no credit margin and this was in the world that was previously in the period before 2007 and banks were seen to be quite worthy and they could borrow at very very cheap levels what's happened since GFC is that in line with new regulation banks have had to post collateral and had to always margin their instruments a lot more and therefore cash is at a real premium often and banks now have to pay a margin over BBSW so the whole curve during GFC both from the strongest borrowers the weakest borrowers borrowers ratchet it up and we're now at a stage where banks have to have to pay a margin over BBSW for their funding when a deal is being discussed the arranger of the deal they work with the borrower to look at comparable deals and to get a feel for what the pricing range should be so when AAI would have been thinking about doing this transaction they would have sounded out their arranger and often their investment banks like EBS and they would have been trying to get a feel for what their cost might be and how much they could raise and so the bank and any sophisticated people can look at similar comparable deals and so aware of these deals being priced, what yields what credit spreads are they being done at and they'll be able to come up with a range which they can quote AAI and say well we think you ought to be able to borrow this much at this price and will that be acceptable so for AAI who's an insurer comparable to him might be QBE and IHE Excellent So here we've got a history of the recent BBSW three months over the last few months and we can see it's pretty much following the cash rates basically when the cash rates drops so there's this rate and it's variation in between those periods will depend on what funding pressures and what liquidity there is so at some times it's much easier to be able to obtain funding than other times and that's why this graph doesn't exactly follow the cash rates and again the spread over the cash rates so I mean specifically that the cash rate is currently at 1 and 3 quarters and the BBSW rates at 2% that 25 basis points difference that spread is also reflective of how available funds are and so coming now towards the end of June or 30th of June there'll be large funding pressures where banks need to actually borrow money to make sure their assets and liabilities match at year end and so we would expect that the BBSW rate itself might go up a little bit and the differential between it and the cash rate will go up a little bit too. It's quite stark this graph Lee isn't it and looking at the Y axis on the right hand side it only goes from and I can't quite read it from here but it's what is it 2.0 It's 195 at the bottom it's 230 at the top and it tells us that the lows being 1.97 and the highs being 2.3 Yes so you get this huge drop in the middle of the screen which actually you know if it was a broader scale it wouldn't look quite so stark but it's quite nice to see it under the microscope if you like and just goes to show how much the cash rate is in the plan. Absolutely and I always people remind me of that because when I first came to Australia interest rates were trading around 18% so if you had a move of 180 basis points 1.8% that was basically a 10% move in absolute terms whereas now if there's 2% then that same move 180 basis points would be virtually 100% and so I often tend to try and look at the move in absolute terms and in financial markets that's typically what they often call see the fact that the actual moves are very different when you compare them to the absolute level of interest rates. Yes a good point and listening to you then I realise that we have been a little bit remiss and not stated what the spreads are we talk in terms of basis points and 100 basis points is equal to 1% so if we say 80 basis points as an 80 basis point spread that actually means 0.8% so with the AAI bond that marginate when it was first issued was 3.3% that's actually 330 basis points so just trying to get you the listeners familiar with our terminology and so just a reminder 1% equals 100 basis points and we're all guilty of being a bit too technical having too many acronyms as well so now if we talk about the movement in price when these notes are issued they have a price of $100 meaning $100 per security so literally to buy one security will cost you $100 and that entitles you to be receiving of an interest rate of as we expressed PBSW plus the margin of 3.30% now that 3.30% is going to be more or less attractive depending overall on how credit spreads move and an example might be that if the financial markets were doing incredibly well and people felt that investing was less risky then if AAI was to do an identical bond a few months later it might be able to issue it only 300 basis points or 3% instead of that 3.30 and therefore if you had a security that was going to pay you $330 which is better and higher as a return to an investor than 300 or 3% then you would be prepared to pay more than $100 for it and this bond would trade above 100 and it would be in the money and the credit spreads is a slightly different concept for all of us and so it took me a while to get our head around but as discussed we can observe the price at which various companies can borrow money at and that's their credit spread and in Australia we're using this index called the iTracks Australia and that is effectively an index of 25 equally weighted investment credit Australian entities and these are household names I have the major banks like BHP, Lendlis QBE, Optus Telstra, Westfarmers Woodside Awards and these big companies we can look at what their cost of borrowing is it's called their CDS and we come up with these iTracks which is that average weighting of those groups and then occasionally there are changes to that index because they need to be of a certain credit quality and the last change actually was earlier this year when Qantas which had been upgraded that came back into the index and they replaced one of the Goodman entities which was removed from the index so here we actually look at the graph of how that iTracks has been over the last 12 months and we can see that it's basically had an average of 126 that means 126 basis points or 1.26% we can consider that as the average number of basis points over a index like BBSW at which companies would expect to borrow it is BBSW though isn't it I believe it is but why I caveat is that some organizations use a different BBSW some use a 3 month BBSW some use a 6 month BBSW so the BBSW is underlying absolutely and we can see it's had a range of between 89 and 171 so that is the average spread the market requires to invest in that basket of 25 absolutely and we would know that if we own that AAI bond where we're earning a spread of around 30 basis points or 3.30% we would expect that when credit spreads of trading on the low side below 100 towards 89 was low for the last year we would expect that bond will be trading above 100 or be in the money because I've got an attractive stream of interest or coupons coming in at being BBSW plus 3.30% and we would expect that when the ITRAX, the credit index trades up around 170 was high in the last year that the AAI bond will be trading below 100 because receiving 330 basis points would not be attractive so that's the way the index works and I feel it's intuitive for people to understand that borrowers do have to pay different amounts of interest depending on their credit quality and so as discussed these changes in the credit spread are attributable to thinking about when this number of basis points is going to be more or less attractive and I really like this diagram on the right that shows how bond prices go up when credit spreads narrow and bond prices go down when credit spreads widen and I just like to think about it about do I own something that's more or less attractive and if I own an asset that's paying me a certain basis points I know it's more attractive when spreads are narrow and credit spreads are down I know it's less attractive when credit spreads are wider so in summary FRNs are really useful products to have as part of a balanced fixed income portfolio we use it in conjunction with fixed rate bonds and inflation products and if we have no real interest rates we might expect our equal proportions of all of those but we use different mixes of these products depending on how we feel about the interest rates environment the interest payments for FRNs combine both the credit spread that's specifically attributable to the issuer e.g. AAIs we've discussed plus it's added to the benchmark rate being BBSW at known periods which might be 3 or 6 monthly and we know that BBSW follows closely regularly observed rates like the cash rate which is linked to our mortgages but it is different because it can be higher or lower depending on funding conditions at those regular periods e.g. quarterly as that BBSW rate moves the interest rate is reset to incorporate the rate payable for that period being the function of the BBSW rate setting plus the credit margin for the specific bond e.g. the 330 basis points for AAIs interest payments are typically set in advance and paid in the rears this might sound like a bit of technical jargon but it just means that the interest payment is set up front for the next quarter so if we had today being the 23rd of June as a rate set period we would set that rate and let's use for example the rate we came out with the 5.3% which is comprised of the BBSW rate of 2% plus the credit margin of 3.30 this would go for the period between June and September and the money would actually get paid in rears on that 23rd of September if the 23rd of September was a good day the FRN price the price of the note will move above and below 100 in conjunction with the issuer and how credit spreads are fairing in general and because of this resetting mechanism that FRNs have where the rate for that period get reset regularly in line with the BBSW they're really, really good in a rising rate environment because you get the benefit of having that reset higher interest rate as rates move upwards which you don't get with fixed rate coupon bonds that's so fantastically you've done really well thank you very much for joining us if you have any other questions please call us on our 1800 number or call one of your local dealers direct there is a lot of additional information available on the wire website thewireatfig.com.au thanks very much for joining us today thanks Liz bye bye