JUNO INVESTING ©

Not all bonds are created equal

JUNO INVESTING ©
Not all bonds are created equal

 

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SPRING 2017

By Paul Gregory, FMA

If you have a KiwiSaver account, you’re probably invested in bonds. Their reputation as a ‘safe’ investment shouldn’t blind investors to the risks, writes Paul Gregory of the FMA.

New Zealanders are investing in bonds, whether they know it or not. Around one in 10 people who respond to Financial Markets Authority surveys say they’re directly invested in bonds – but exposure to bonds across New Zealand investors is far wider than this. 

The reason is that bonds play a big part in KiwiSaver and the portfolios of those of us who are among its 2.6 million members.

The number of bonds in any KiwiSaver fund varies, depending on the type of fund. But nearly all funds, except for most aggressive funds, will have them. Conservative funds, making up nearly a third of all KiwiSaver investments, have a greater percentage of bonds than shares. 

Around 900,000 New Zealanders have total investments of $9.2 billion dollars in these funds.

It’s also clear that while New Zealanders like bonds, they’re not so fond of risk. It’s not just New Zealanders who think that way. 

Fund manager Blackrock surveyed small United States investors. Almost half told researchers you couldn’t lose your money in fixed-interest assets or bonds. Around the world, investors generally assume bonds are safe.

How do bonds work?

When you buy a bond, you’re lending money to a company or government authority. You’re lending them your capital for a fixed period of time, for an agreed amount of interest. All being well, you get your capital back when the bond matures.

People invest in bonds because they generally offer more stable returns for less risk. Many bonds are listed on financial markets, so holders can trade bonds before they mature. 

The more trades there are, the easier it’s likely to be to sell your bonds. Few buyers mean you could struggle to sell.

The key information about any bond is its interest rate and credit rating. 

• The interest rate is the return you get while holding it. 

• The credit rating helps you understand how likely it is you will get your money back at maturity, and that interest will be paid on time. 

A lower credit rating and a higher interest rate often, but not always, go together, as they can be a sign of the bond being riskier. Certainly, some bonds are riskier than others.

Rising interest rates

This is particularly relevant now. The United States Federal Reserve is raising interest rates. When the financial markets expect interest rates to rise, the value of bonds can fall. This is because the interest rate on new bonds is expected to be higher, so people prefer them to previously issued bonds. 

If you’re holding a bond for the cash flow and are happy, then you can hold on to the bond until maturity. But you’ll be getting a lower return, compared to the holder of a newly issued bond, with a higher interest rate. And if you want to sell your old bond, there will be less demand for it, which will affect its value.  

Rising interest rates may also have an impact on the value of conservative KiwiSaver funds, at least in the short term. 

Conservative funds are invested in by people who have a very low tolerance for risk, but investors in these funds should understand the impact of rising rates on bonds. Investors in bonds can take solace, though, that when bonds lose value, riskier assets such as shares have been known to record bigger falls.

New bond types

Investors looking for better interest rates need to know there are many reasons why bonds can have a higher interest rate. Often, it’s because they’re higher risk. 

New types of bonds have appeared in the last few years. A number have been issued in New Zealand. Many have interesting names, such as ‘cocos’ (contingent convertible bonds), ‘hybrid securities’ or ‘bank capital notes’. They’re often issued by well-known banks or companies, but they have special features which may make them unsuitable for many retail investors. 

The bond issuer may be able to stop or limit the interest they pay. Some bonds can be converted into shares at the issuer’s choice, with the potential for the shares to be worth less – potentially much less – than the sum originally invested. 

These types of bonds were created after the global financial crisis to reduce the risk of a bank going under. The terms of the bond are designed to protect the stability of the financial system. Instead of taxpayers bailing out a bank, investors holding these notes bail out the bank instead.

Holding bonds

Investors should value bonds for the income stream they deliver. When markets are jumpy, investors should ask themselves: are my bonds delivering the return I need, over the period I need it, with no doubts that this will continue? 

They should also ask, do I really need to sell just because other bonds look like better earners?

Of course, an investor might not be comfortable with what they have. Or they may need – or want – a higher return. If so, investors should be conscious that the promise of better returns can be fragile. 

So your best defence is thinking hard, doing your research, getting help or consulting an adviser, and choosing well.