Floating Rate Notes have Outperformed Term Deposits

The table below details the highest margins Amicus observed during August for Term Deposits and FRNs issued by reputable ADIs in Australia relative to three month BBSW rates. We contrast Major Bank rates with those of Non-Major ADIs (Regional and Offshore Banks, larger Credit Unions and Building Societies) and detail how these credit margins have varied over the last year.

Term Deposit margins for Major Banks contracted by 5bps in August relative to July and are 22bps less than they were three months ago, but only 13bps and 11bps less than they were six and twelve months ago. A similar pattern is exhibited for Regional Banks except that margins have contracted slightly more and notably credit margins increased in August due to a “special” being run by a non-major bank.

In contrast FRN margins have contracted considerably.  The reduction has been less in August than in June or July, however, compared with six months ago trading margins on 5 Year Major Bank FRNs have reduced from 115bps to 44bps and from 120bps to 54bps for 3 Year Regional Bank FRNs.  The contraction over twelve months has been even greater with margins reducing for Major Bank FRNs by 87bps and for Regional Banks by 83bps.

The primary cause of the contraction in credit margins has been the actions of the RBA who have taken significant steps in response to the COVID-19 pandemic. In particular the Term Funding Facility (TFF) offered to ADIs has had two major effects. Firstly, combined with other actions taken by the RBA it has sent the strong signal access to funding should not be a concern for any ADI and as a result it is extremely unlikely any ADI will fail for liquidity reasons in the short term (failure due to solvency issues caused by loan losses in a souring housing market remains a longer term concern). Hence for fundamental reasons premiums for shorter term credit risk should have declined.

The second and larger factor is the RBA has offered all ADIs access to TFF where they can borrow monies at an absolute interest rate of 25bps for 3 years. This has caused credit margin contraction for technical issues being that borrowing from the market by major banks has largely ceased as the major banks are now borrowing from the RBA using the TFF. This makes absolute economic sense as with the RBA holding 3 year government bond rates at 0.25%, ADIs are effectively being offered funding without any premium for and credit risk over that of Australian government debt. The lack of supply in the market while demand is largely unchanged has led to the recent contraction in margins.

The TFF has impacted debt securities in the form of fixed and floating rate notes to a greater degree than Term Deposits meaning the capital price appreciation these assets has been greater for those investors that held them. In contrast at current yields Term Deposits potentially offer better value paying a higher credit margin for a shorter term of investment, although they are not tradable and offer less liquidity. Nearly all investors who bought floating rate notes will be enjoying large capital gains on their investments.

With the TFF recently being extended, it does not appear the supply demand imbalance will be rectified anytime soon and in fact will only truly reverse in 3 years time when (presumably) money borrowed via the TFF will need to be refinanced in the open market. As with interest rates it appears credit margins will now be lower for longer; unless obviously any fundamental risks of default emerge.

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