Banks swap one concern for another

On top of a challenging couple of weeks for the banks in the media, the banks' domestic funding costs are already beginning to increase due to recent increases in the short-term Bank Bill Swap Rate (BBSW) - the benchmark interest rate used to set interest rate swaps by financial institutions.

In recent months we have witnessed a sharp spike in a number of short term rates, particularly notable in the 90-day BBSW. From early March we have witnessed it spike from below 1.80 per cent - where it had remained since mid-2016 - to almost 2.10 per cent by mid-April. While it has subsequently receded marginally, it remains about 1.95 per cent; a substantial rise. Local banks borrow about 40 per cent of their funding in this short-term market. As such, a rising BBSW will have a significant effect on lending markets, despite the RBA's extended "no change" policy.

The exact cause of the spike in the swap rate is unclear. A popular explanation links it to the recent rise in US ntreasuries issued to fund Trump's tax reform, coupled with the "amnesty" to large US corporations with offshore earnings to repatriate these funds from markets such as Australia, reducing local demand and sending swap rates higher.

While such a spike raises concerns as to the stress levels in financial markets, a continued spike in the short-term funding rates is also tricky for the banks; given the spotlight on them as a result of the banking royal commission. Any attempt to raise mortgage rates out of cycle with the RBA cash rate will likely raise the ire of politicians, newspapers and homeowners alike.

However, these tough times for banks may be good news for investors. While the RBA cash rate remains unchanged at historical lows - continuing to place strain on yield-seeking investors - other investments' (such as bank hybrids) distributions are set to a margin above the 90 and 180-day swap rates; with this rate reset at every 90 or 180-day period respectively. As a result, we are beginning to see higher swap rates flow through into the distribution rates of some of the hybrid securities, with some securities already reflecting this increase in the upcoming June distributions.

While the increase may only provide a small increase in income to individual investors, in current conditions any additional income is a welcome relief, particularly for self-funded retirees.

While investments such as hybrid securities carry risks, a continuation of elevated swap rates may make such investments more attractive to investors.

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Daryl Dixon

Executive Chairman

Daryl Dixon is one of Australia’s foremost investment experts and a well known writer and consultant. He has provided trusted advice to thousands of personal clients over more than 25 years and is an acknowledged expert in the areas of tax, superannuation (including public sector superannuation), social security and investments.

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