Fixed-interest headwinds at hand

One of the interesting observations about the Covid-19 pandemic is how quickly the public can be educated about very scientific concepts.

Who would have thought that the mechanisms of virus transmission and the calculation of a virus R number would be the topic of mainstream media? I guess that when any subject has a significant impact on our everyday lives we are incentivised to learn.

We are about to experience something in investment markets which, although it won’t have quite the same dramatic impact of Covid-19, will negatively affect the wealth of many New Zealanders.

We are soon likely to see interest rates rise — resulting in the value of investors’ bonds falling. This seems highly counterintuitive.

Investors are right to be baffled as to how the fixed-interest component of their KiwiSaver could drop in value at a time when interest rates are rising.

In simple terms, this situation occurs when new fixed-interest investments are available which pay a higher interest rate.

This causes existing bonds (that pay a lower interest rate) to become less valuable. In a fund or portfolio where investments are "marked to market" every day (i.e. revalued according to their current market price), this reduction in value becomes immediately visible.

The 30-year "free ride" for bond investors is about to come to an end. By this I mean that over the past 30-plus years we have seen interest rates progressively fall.

As a result, bond investors have seen the interest income they receive progressively reduce but have been handsomely rewarded by an increase in the capital value of the bonds they hold.

At the outbreak of Covid-19, central banks across the world further reduced interest rates

(i.e. the cost of money) to all-time lows.

This resulted in bond funds experiencing a further lift in value.

However, now that the prospect of negative interest rates in New Zealand appears to have receded, the next movement of interest rates is likely to be up.

I am not forecasting a dramatic increase in interest rates, but the increases don’t have to be great to depress returns.

When you consider that a "balanced" portfolio might hold 40% of its capital in bonds, and that the return on that part of the portfolio is likely to be restrained by this phenomenon, then you can see why I am cautious.

I sometimes use a sailing analogy with my clients by explaining that the fixed-interest part of their portfolio can be likened to the keel of a yacht; it provides the counterbalance to the shares within the portfolio. In this way it usually helps to stabilise returns.

However, in a rising interest rate environment, we sometimes experience short periods where interest rates rise unexpectedly.

When this occurs, share values can fall sharply, and bond values also fall. As a consequence, the fixed-interest part of the portfolio fails to provide a counterbalance, the resulting sharp fall in value across the entire portfolio can be very disconcerting for investors.

In these circumstances, it is the investors with higher fixed-interest holdings (usually the more conservative investors) who suffer the higher losses. When you consider that a KiwiSaver default fund is required to hold 80% of its assets in cash or fixed interest at present, you can see why I am concerned.

So what should investors be considering in advance of these events?

1.Understand that the fixed-interest part of your portfolio will not always be capital stable.

2.In an increasing interest rate environment, the returns from a traditional "balanced" asset allocation might struggle to produce their historical average returns.

3.Active management of the bond part of your portfolio can help protect value by reducing the exposure to this phenomenon, known as interest rate risk.

4.A few fixed-interest managers do employ active management techniques to ensure that the value of the bond part of the portfolio will directly benefit when interest rates increase. This is something to ask your financial adviser about.

If Covid-19 has taught us anything over the past year, it is how unanticipated consequences can occur during times of change. For some, these consequences present opportunity; for others, a risk. It all depends on how well your capital is managed.

Peter Ashworth is a principal of New Zealand Funds Management Ltd and an authorised financial adviser based in Dunedin. The opinions expressed in this column are his own and not necessarily that of his employer. His disclosure statements are available on request and free of charge.

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