How rising interest rates can benefit your portfolio

Following the Reserve Bank of Australia's decision to increase the cash rate for the seventh month in a row, the big banks and other deposit takers have been raising interest rates on their savings accounts and term deposits as they seek to expand their deposit books.

At the same time, other fixed income investments are also yielding more as income options expand.

For savers who rely on cash and term deposits for income, interest rate rises are good news.

According to data from the Reserve Bank of Australia, the average rate on banks' bonus savings accounts rose to 2.55% p.a. from 2.25% p.a. in September, and has surged from a paltry 0.25% p.a. a year earlier.

Average interest rates on one-year term deposits being offered by the big banks jumped to 2.7% p.a. in October from 1.5% p.a. in September while the average interest rate on three-year term deposits virtually doubled to 3.2% p.a. in October from 1.65% p.a. in September 2022.

What some savers may not know is that there are more fixed income investment options available to savers than simply online savings accounts or term deposits.

Some bond investments too are yielding more now that interest rates are rising and returning more than either term deposits or savings accounts.

Fixed income ETFs that may benefit from rising rates

For income-seeking investors who are willing to take on a little bit more risk than that involved with a cash deposit, some exchange traded funds (ETFs) offer exposure to bonds with a variable interest rate coupon that rises with interest rates.

These bonds are known as floating rate notes (FRNs); given their coupon is variable, and rises with market interest rates, the value of the bond is not as sensitive to rising interest rates as fixed rate bonds, such as government bonds.

So, while the price of fixed-rate bonds typically goes down when rates rise, FRNs offer a greater degree of capital stability in a rising rate environment than government bonds.

Reflecting that, while many bond funds are down around 12% or more this year, the Solactive Australian Bank Senior Floating Rate Bond Index is up 0.09% over the one year to October 2022.

Importantly, FRNs aim to provide income that increases in a rising rate environment. That means that the yield earned on FRNs has the potential to increase over the next 12 months, whereas the interest rate on a 12-month term deposit today is fixed. The same is true for a three-year term deposit.

An ETF which invests in FRNs has other benefits over term deposits.

ETFs are more liquid as a result of the fact that investors can buy or sell an ETF on the ASX with T+2 liquidity, or within three days, which means they don't need to lock away their money for several months or years.

Furthermore, if you've locked away your money for a year or more, you won't get any benefit from a rate rises. In contrast, the yield on FRNs typically benefit from any future rate rises.

In the past, it has been difficult for retail investors to buy FRNs, which are a type of corporate bond. But ETFs have made it possible for investors to hold a portfolio of FRNs, which can enhance the defensive part of their portfolio when interest rates are rising and share markets are expected to remain volatile.

The BetaShares Australian Bank Senior Floating Rate Bond ETF (ASX: QPON) invests in senior FRNs issued by Australian banks, which are among the most liquid and highest credit-rated corporate bonds issued in Australia. QPON is currently delivering an all-in yield of 4.08% p.a. (as at November 16, 2022) and market pricing suggests that all-in yield will continue to rise to close to 5% p.a. in six months' time.

If, however, you are a conservative investor and don't want to take on more risk than cash investments, interest rates on cash savings accounts are the highest they have been for several years. The BetaShares Australian High Interest Cash ETF (ASX: AAA) invests in cash deposit accounts held with select banks in Australia.

As at November 16, 2022, the interest rate earned on AAA's deposits sat at 2.97% p.a., after fund management fees and costs, a significant uplift than the interest rates on many banks' savings accounts.

In addition, AAA pays monthly income and has the added benefit of being exchange-traded, so investors have greater flexibility to deploy their capital if a buying opportunity emerges.

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