One way rising interest rates could help, not hinder, your portfolio

Key points

  • “Floating rate notes” are a type of corporate bond linked to variable interest rates.
  • Floating rate notes payments generally rise in a rate rising environment.
  • They currently yield more than term deposits.
  • In the past, it has been difficult for retail investors to buy floating rate notes.
  • Some ETFs offer exposure to floating rate notes that pay a monthly income.

In a year when interest rates have risen for seven consecutive months, there’s little in the way of silver linings for investors. For those with a mortgage, rate rises are rarely welcomed, and those with savings in the bank are only just now starting to see higher returns on their hard-earned savings.

The big four banks have recently raised interest rates on 12-month term deposits to between 3.75 per cent and 4.00 per cent, per annum. However, for these returns, investors won’t be able to access their money during the fixed period without sacrificing part, or potentially all, of the interest earned. And locking a fixed rate in now may mean missing out on higher rates later if cash rates continue to rise.

Portfolios always benefit from holding assets that protect them against volatility, but just as with equities, the inflation outlook is a game changer for bonds.Credit:Simon Letch

What investors might not realise is there are other fixed-income investments that pay higher rates of interest when compared with term deposits while offering much greater liquidity.

These investments are called “floating rate notes”, and they currently yield more than term deposits. For example, the Solactive Australian Bank Senior Floating Rate Bond Index now has an all-in yield of just over 4% p.a. Floating rate notes are a type of corporate bond where the payment or coupon on that bond is linked to variable interest rates, so will generally increase in a rising rate environment.

With the expectation of at least three more official rate rises to come in Australia, the yield earned on floating rate notes may increase over the next 12 months, unlike the interest rate on one-year term deposits which are fixed.

For income-seeking investors who are willing to take on a bit more risk than that involved with a cash deposit, some exchange-traded funds (ETFs) offer exposure to floating rate notes which typically pay a monthly income. Unlike term deposit holders, who won’t get any benefit from a rate rise, investors in these ETFs benefit from the bond’s variable coupon, which typically rises with any future rate rises.

Not only can investors reap a higher yield, but they can access their money when they need it, and the funds can easily be bought or sold on the ASX through a stockbroker with T+2 liquidity – meaning you can access your money within three days of selling your ETF units, and you ultimately don’t need to lock away your money for several months or years like is the case with a term deposit.

When compared to other fixed-income investments, floating rate notes – which are often issued by the big banks – offer more capital stability in a rising rate environment than other types of bonds. Reflecting that, many bond funds are down about 12 per cent or more this year, while the Solactive Australian Bank Senior Floating Rate Bond Index is flat over the one year to the end of October. Another benefit of floating rate bonds is they have historically exhibited low correlation to equities, so can help insulate against volatility on the sharemarket.

In the past, it has been difficult for retail investors to buy floating rate notes, which are a type of corporate bond. But ETFs have made it possible for investors to hold a portfolio of floating rate notes, which can enhance the defensive part of investors’ portfolios while interest rates are rising and share markets remain volatile. For investors who are interested, there are several ETF products listed on the ASX which invest in floating-rate notes.

Cameron Gleeson is a senior investment strategist with BetaShares.

  • Advice given in this article is general in nature and is not intended to influence readers’ decisions about investing or financial products. They should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.

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