Weekly Insights BY THE CURVE TEAM –

Weekly Insights – Opportunities From Fixed Loans

16th of August, 2021

Key Updates

  • Tuesday – RBA Minutes for the August Meeting
  • Wednesday – Wage growth for Q2
  • Thursday – Employment for July

Fixed Loan Surge Creating Opportunities

Fixed loans have become more prominent in the current interest rate environment. Many fixed rate loans are below variable equivalents, whereas prior to covid the opposite was the case.

The RBA’s Term Funding Facility is a major factor, with ADIs having borrowed at a rate of 0.10% to be repaid in 3 years. This locks in a cheap source of funding for a long period of time, which ADIs can lend out at similar tenors and low rates. For example, if an ADI borrows $10 million from the RBA at a rate of 0.10%, they could lend these funds at a rate of say 2.10% for a 3-year term. Assuming the borrower repays the loan with interest, the ADI would lock in a 2% margin.

Offering a fixed loan for a longer term carries interest rate risk, which ADIs need to monitor closely. ADIs try to mitigate this risk to ensure profitability would not be affected if interest rates increased or decreased.

Ways to reduce or remove interest rate risk is by entering swaps, which transform a cash flows associated with the loan from fixed to floating. Another is by funding those loans from a fixed source of a similar tenor, as in the example of the 3-year loan.

As ADIs return to wholesale and middle markets to raise funds rather than relying on a bonanza of retail funds and the TFF, there is every chance they will prefer longer term fixed deposit rates. This would allow ADIs to match their fixed loans with a fixed liability, which reduces interest rate risk.

This is especially relevant in the current market, which operates very much like a quota system. Overall appetite for funds is low, so when ADIs are happy to take funds it is in designated amounts. We believe ADIs will also be more selective about the terms they wish to offer, as to match up with their assets. There was evidence of this last year, with some ADIs offering fixed 2-3 year term deposit rates after the first round of TFF expired in September.

The barbell strategy discussed last week links well with this outlook. The yield curve at the moment is very flat out to three years, which means there is only a marginal benefit by investing for 1-3 years. Should the curve steepen from 1-3 years, having a large portion of the portfolio as short term or cash allows investors to take advantage of the rise in rates.

Josh Stewart

Associate - Money Markets