It's not easy to solve the interest rate dilemmas for investors or borrowers

By Roger J Kerr

Fixed interest investors who have been investing their funds in short maturities to benefit from higher short-term and long-term market interest rates later this year have just experienced a sharp lesson in "event risk" with the Christchurch earthquake and the OCR cut keeping interest rates now much lower for much longer.

It does not pay to have all your eggs in one basket; however you might be surprised at how many retail investors have never invested their money for terms greater than 12 months.

These investors may have been getting 5% deposit rates from the banks over the past year, however many banks have now slashed such rates to 4% because they no longer need to attract money in as they are not lending it out the other side.

The now steep upward slope of the yield curve tells us that the markets expect interest rates to increase sharply in 12 months time.

Can and should retail investors be patient and wait for the uptick, suffering the lower returns in the meantime?

Or should retail investors buy a five-year corporate bond in the marketplace today at 5.8% - 6.0% and be happy at that return?

As always, the answer is somewhere in between, emphasising the requirement to have a mix of both short-term and long-term investments in the portfolio, so as to have some hedge against the type of event risk we have just seen.

Borrowers

There are similar sorts of challenging yield curve/market risk questions for borrowers as well at this point in time.

Corporate borrowers with high levels of fixing out to 10 years forward with swaps will be viewing the "opportunity cost" of paying between 5% or 6% under fixed-rate swaps against floating rates now below 3%.

The problem with switching immediately to a higher level of floating is that when these rates start to increases in early 2012, the three to 10-year market swaps rates will be substantially higher than where they are now.

It makes no sense to close-down long-term swaps now and go floating, unless those long-term swaps were entered at the market lows of 4.50% and 4.75% (24 months and seven months ago) and are heavily in-the-money.

These swaps can be shortened in term to generate lower one to five year swap rates. I would hold-off from transacting these shorteners until seven to 10 years swaps rates move up another 40 or 50 basis points.

For new borrowers or borrowers forecasting increased debt levels, there must be merit in fixing 60%/70% in the three to five year maturities at the current swap rates of 3.70% and 4.35%, given the NZ growth and inflation outlook after 2011.

I do not see these three to five year swaps rates going any lower than where they are now.

Forecasts

APRM’s updated forecast is for the three and five year swap rates to be 1% higher in 12 month’s time.

That forecast is based on US 10-year Treasury Bonds moving higher and dragging the three to 10-year NZ swaps up with them. Add on the 2012 inflation and growth scenario and such forecasts may not be too far wide of the mark.

While US Treasury Bond yields have moved down recently to 3.4% on the investor flight-to-quality from the Middle-East tensions, all the other inflation, growth and employment leading indicators in the US economy point to 4% yields over the next 12 months.

As mega-fixed interest fund manager in the US, Pimco, say "who is going to buy US Treasury bonds when the Federal Reserve stop buying their USD75 billion per month when the QE2 programme ends in June?"

The massive Fed buying to date has hardly forced yields lower; remove that buyer from the market and the sellers take over. For this simple reason it is very easy to forecast US 10-year Treasury bond yields increasing to 4% this year. Again, add on the higher inflation and economic growth factors and the forecast takes on some reasonable credibility.

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 * Roger J Kerr runs Asia Pacific Risk Management. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com