Fixed interest investments. Are you being compensated enough for the risks?

Did you know you can actually get a negative return from fixed interest investments? After all, they are supposed to be the safe part of an investor’s portfolio! Well generally they are, but it’s important to understand the types of risks associated with investing in fixed interest instruments and what situations could result in a negative return.

There are lots of different fixed interest investments. They generally have the characteristics of an agreed amount of money lent by an investor (or lender) to a borrower for a fixed term and repaid to the lender at the end of the term with interest paid throughout at an agreed rate. Fixed interest investments are often called “bonds” and for simplicity we will refer to them as bonds for the remainder of this article.

The four main risks associated with investing in bonds are;

Credit risk: the risk the borrower can’t pay the interest agreed or even worse, can’t repay the money they borrowed. We saw this happen in New Zealand during the global financial crisis over a decade ago when many of the finance companies operating at the time defaulted on both interest and the repayment of money they borrowed, resulting in investors losing most if not all of their original investment. Many of the finance companies of the time don’t exist today. Names like Hanover, Capital and Merchant, Bridgecorp, Strategic Finance and South Canterbury Finance come to mind. The global financial crisis was a reminder that not all bonds are equal and those of low quality can default at times of financial stress.

Inflation risk: this is the risk inflation will rise at a rate greater than the interest being earned on bonds. As a result the future purchasing power of the investment (plus interest) is lower than its current purchasing power. We are in this situation today. Using the NZ Composite Bond Index* as a proxy, the yield to maturity (the future return per annum taking into account the current price of the bonds in the index and the future interest to be paid on the bonds) is currently 1.3% per annum. The after tax rate of return is likely to be around 1% per annum or less. With the annual change in the consumer price index currently running at 1.5% per annum, the real (after tax and inflation) return for bond investors is actually negative.

Liquidity risk: this is the risk investors are not be able to sell (or buy) bonds quickly at a price representing fair value for the bond. Bonds in the NZ Composite Bond Index are all listed on the NZX and available for sale or purchase in the secondary market. Bonds not listed on the exchange may be more difficult to sell with a worst case scenario of holding them until they mature.

Interest rate risk: this is the risk of a change in the value of existing bonds caused by a change in market interest rates. Interest rate risk is not generally relevant to investors who buy bonds directly and hold them until maturity, unless due to unforeseen circumstance they need to sell them prior to maturity. They simply get the interest rate agreed upfront and expect their investment back on maturity. Interest rate risk is very relevant to investors who buy and sell bonds on the secondary market and also for investors who access bonds through managed funds, which is commonly to case.

To explain further, interest rates change from time to time based on the economic environment and market conditions. New bonds are issued based on prevailing market interest rates. If investors buy a newly issued bond paying interest at say, 4% per annum and market interest rates subsequently drop to say, 3%, the bond paying 4% is more attractive than a newly issued bond paying 3%. What this means in practice is an investor selling a bond paying 4% when the prevailing rate is 3% expects to sell their bond for more than they paid for it. The amount they expect for selling the bond is equivalent to the amount the buyer would have to pay to receive a 3% per annum return through to the maturity of the bond. Putting it another way, the buyer will need to pay more for the bond than they will receive when it matures (this is called buying at a premium) but they are compensated for this by getting the higher interest rate of 4% than the prevailing rate of 3%.

Confusing? Let’s look at a real life example. The following table shows the returns for the NZ Composite Bond Index for the last 5 years with the 2019 number being for the 11 months to the end of November.  Alongside the annual returns is the yield to maturity for the index at the end of each year. This represents the return per annum an investor would expect to receive through to maturity of the bonds in the index assuming no future changes in market interest rates. The current average maturity date is 5.8 years.

 

Year ending Total return for the year Yield to maturity
2015 5.4% 3.1%
2016 3.6% 2.7%
2017 5.6% 2.4%
2018 4.6% 2.2%
2019 6.6%* 1.3%
*11 months to November

 

You’ll notice a couple of things from the table. Firstly in each instance the return for the year is greater than the corresponding yield to maturity. Secondly the yield to maturity has progressively dropped over this 5 year period to a low of 1.3% per annum.

The reason the total return is greater than the yield to maturity is interest rates have progressively dropped over the period and as mentioned earlier, this makes existing bonds more valuable. Therefore a good part of each of the last 5 years’ returns (particularly 2019) represents capital gains attributable to falling interest rates.

The question now is how far can interest rates fall from here? With a yield to maturity of just 1.3% for the index, we are getting ever closer to zero. If interest rates continue to fall we will continue to see a total return that exceeds the yield to maturity. But just how low will interest rates go. It’s hard to say but if there were no changes in interest rates for the foreseeable future then the return on average each year would be equivalent to the yield to maturity of 1.3% per annum which is in stark contrast to the average total return over the last 5 years of approximately 5.2% per annum.

Falling interest rates has been a long term trend going back the inflationary 1980s as can been seen from the graph below.

 

10-year-NZ-government-bond-yeilds

Source: RBNZ

Investors have enjoyed the tail winds of these falling interest rates over this period delivering attractive capital gains. However, like riding a bike down a long hill, it is only a matter of time before being faced with an uphill slog. In investment terms this means the reverse of what investors in bonds have been experiencing of late. As interest rates rise, the value of existing bonds fall. Have we been here before? Absolutely. In 2013 bonds delivered a return of -1.2% and back in 1994, a return of -2.8%.

At current interest rates which are lower than through much of history, a 1% rise in interest rates would equate to a decrease in value of the NZ Composite Bond Index of around 5%. Bonds with longer time frames to maturity are even more sensitive to increases in interest rates.

To provide a very long term perspective, it is quite normal for interest rates to be low. Based on US 10 year Treasury data dating back to 1871, the average return is 4.5% per annum. If we take out the inflationary decades of the 1970s and 1980s, the average return drops to 3.8% per annum, and if we look at the 3 decades starting with the 1930s, the average return was just 2.7% per annum. Should we be expecting interest rates to rise to anything like the dizzy heights of the 1980s? No, but given the very low interest rates we are experiencing today, even modest increases in interest rates can have a negative impact on the value of existing bonds.

Now we’re not suggesting investors rush out and sell their bonds as they play an important role in a diversified portfolio around preservation of capital and reducing volatility of investment returns over time. However it is important for investors to realise the recent returns from bonds can’t continue forever and there will be years where the returns can be negative.

In summary, one of the most likely ways of getting a negative return from bonds in the current environment is through rising interest rates. There’s no immediate sign of that happening for now but investors should expect the end to falling interest rates at some point and inevitably higher interest rates from where we are today.

If you want to know more about the impact of bonds on your portfolio, speak to one of Saturn’s financial advisers.

*S&P/NZX NZ Composite Bond A Grade NZD

The views expressed in this article are the views of the author. The information provided is of a general nature and is not intended to be personalised financial advice. You may seek appropriate personalised financial advice from a qualified Authorised Financial Adviser to suit your individual circumstances.



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