Big news has broken about inflation in the last week. You may have read headlines such as “Monthly Inflation Retreats to 5.6%.” Those headlines don’t tell the full story. As I’ve pointed out in previous updates, those figures refer to the annual movement in CPI, not the monthly movement. In other words prices, as measured by CPI, rose by 5.6% over the 12 months between May 2022 and May 2023. It doesn’t tell us a great deal about what happened to CPI, or prices, specifically during May 2023.
In May, overall CPI was 119.0, down from 119.5 in April. This implies that prices actually fell by 0.42% in the month of May. Seasonally adjusted CPI was 119.2 in May 2023, and 119.2 in April 2023, which implies no change in prices. Be mindful there are many ways to look at inflation and different baskets of goods can be considered to get different outcomes. However, it is likely that these inflation numbers gave some comfort to the Reserve Bank of Australia (RBA) during their meeting this month. In yesterday’s RBA Media Statement, it was stated, “Inflation in Australia has passed its peak and the monthly CPI indicator for May showed a further decline.”
Accordingly, the RBA paused interest rates at 4.10%, at yesterday’s meeting. This should give businesses and consumers some comfort as it may take away some of the anxiety associated with increasing debt servicing costs. That comfort, in turn, will hopefully flow through to investment decisions and help buoy the economy, which would be good for everyone. It’s important to keep in mind that a pause now is not indicative of an indefinite pause, and the RBA will continue to monitor inflation closely.
While the May CPI result is a great sign, we believe the signs and prospects for future inflation are mixed. On the one hand, commodity prices, largely, are not displaying inflationary signals. However, there is the potential for future inflation pressure from other areas such as increasing energy costs, wage costs and rent costs. The RBA will no doubt be keeping an eye on this, and may increase rates further if it believes it needs to, to control inflation.
In the RBA’s words: “Some further tightening of monetary policy may be required to ensure that inflation returns to target in a reasonable timeframe, but that will depend upon how the economy and inflation evolve. The decision to hold interest rates steady this month provides the Board with more time to assess the state of the economy and the economic outlook and associated risks.”
While higher interest rates are a source of discomfort for many parts of the economy, they have various implications for different types of investments, particularly for investors who hold income portfolios with exposure to debt-related instruments.
Fixed-rate bonds are debt instruments issued by governments and corporations to raise debt funding. They can be bought and sold on secondary markets at values higher or lower than their issued value, and are often held by investors indirectly, via units in a trust. They pay a fixed interest payment, sometimes called a coupon. When market interest rates rise, these bonds do not pass the increase on to the bond holder, and the bond’s value, in secondary markets, will likely drop. So, if you hold units in a bond fund, during a rising interest rate environment, the value of your investment may actually fall.
This is in contrast to a floating rate bond or floating rate note. These are also debt instruments, typically issued by corporations. These instruments base their interest rate on a reference rate that is tied to the broader movement of interest rates in the market (e.g. the 90 day Bank Bill Swap rate or BBSW). This means that when interest rates rise, these instruments will typically increase the interest paid to the bond holder.
In rising interest rate environments, economies typically slow down, and consumption falls, making it harder for companies to do business. Money itself becomes more expensive, making it harder for businesses to invest in growth and in some cases manage cashflow. It’s important to note that when interest rates are higher, and/or if the economy has headwinds, there are additional risks to take into account when considering corporate debt of any kind. Difficulties faced by companies could impact their ability to repay debt and could impact the value of bonds they have on issue. In this kind of environment, tax receipts can also fall (due to slower economic activity and potentially higher unemployment) and social security costs can increase (due to higher unemployment). In some cases, governments may spend more to try and stimulate the economy which could impact its deficit/surplus position, and just as money becomes more expensive for the private sector, it too becomes more expensive for governments to service their debt. This can impact sovereign credit ratings and have broader implications for the value of government bonds.
Mortgage trusts are another source of income for investors. These trusts raise money from investors and lend money to borrowers to purchase or develop property, with the debt secured by registered mortgages. One of the benefits a mortgage has for lenders (or investors), is that in the event of default, the asset(s) against which the mortgage is held may be sold to repay debt to the mortgage holder. This provides a mortgage lender (and by extension an investor), an added level of security compared to unsecured loans. Mortgage trusts typically hold first registered mortgages and/or second registered mortgages. As the terms would imply, first registered mortgages rank above second registered mortgages in the event the mortgaged assets need to be sold to repay debt. So in comparison, first registered mortgages are less risky (for lenders), and provide better security (to lenders), than second registered mortgages.
Mortgage trusts can focus on various types of borrowers. Some borrowers require financing to purchase their own home, or to buy an investment property. The terms on these residential mortgages will vary but borrowers can often require many years or even decades to pay off their mortgage. In a rising rate environment, the cost of living for borrowers increases and during economic slowdowns, their employment prospects may be impacted.
Other borrowers require funding from a mortgage trust to finance a property development project. The terms on these loans also vary and can be based on the time a project will take to deliver, or the time the phase of the project being funded by the mortgage may take. Ultimately, loans could be for a few months or many years. In a rising interest rate environment, property developers face the same potential increase in debt servicing costs that other borrowers face, in addition to potentially increasing costs of doing business and finishing projects. All the individuals and businesses that service a property developer face different challenges when interest rates rise, and these in turn flow through as potential risks to the property development projects.
If interest rates rise, the loans held in a mortgage trust may have mechanisms that give the Manager the discretion to pass the increase on to borrowers. This typically would enable a better return to investors. Factors that could impact this is whether the loan agreements have fixed or variable rate components within their terms, the term to maturity of loans in the portfolio, the ability to roll funds into loans at new rates and also the competitive forces facing the markets that different funds operate in. The Trilogy Monthly Income Trust provides finance to primarily property developers, secured by registered first mortgages. The trust generally writes loans with a term of two years or less. As at May 2023, two thirds (66%) of our portfolio was invested in loans that are expected to mature in six months or less. Over 90% of the portfolio was in loans expected to mature in 12 months or less. Furthermore, we retain full control over any lending rate adjustments under our loan agreement with each borrower. This has enabled us to increase rates to investors numerous times over the course of the last 15 months – but it is important to note that past performance is not an indication of future performance.
This article is issued by Trilogy Funds Management Limited ABN 59 080 383 679 AFSL 261425 (Trilogy Funds) as responsible entity for the management investment schemes mentioned in this article. Application for investment can only be made on the application form accompanying the relevant Product Disclosure Statement (PDS) and by considering the Target Market Determination (TMD) available at www.trilogyfunds.com.au. The PDS contain full details of the terms and conditions of investment and should be read in full, particularly the risk section prior to lodging any application or making a further investment, together with the TMD. All investments, including those with Trilogy Funds, involve risk which can lead to no or lower than expected returns, or a loss of part or all of your capital. Trilogy Funds is licensed to provide only general financial product advice about its products and therefore recommends you seek personal advice on the suitability of this investment to your objectives, financial situation and needs from a licensed financial adviser. Investments with Trilogy are not bank deposits and are not government guaranteed. Past performance is not a reliable indicator of future performance.