Are Bonds Still the Right Choice?

Bonds used to be a safe haven. But Jack Powell, of Private Wealth Advisers, suggests you check if they’re still the best place for your money.

Over the past decade, we’ve seen local interest rates drop to record-low levels. This has been a great environment for investors who’d been holding bonds for a long time.

Just think back to 2006-07, when you could get a good-quality bond paying more than 8 per cent interest.

If you go back over the past 5,000 years, the only other time interest rates were this low was in the 1930s during the Great Depression.

Why central banks printed money

In the Global Financial Crisis (GFC) of 2008, share markets were falling and bank credit was freezing up.

Central banks around the world feared that if money flow froze, economies would slide into another global depression.

So, the US Federal Reserve started quantitative easing (QE), which basically means it was printing money and using it to buy its own government bonds.

This increased the demand for US bonds, pushing up their price and reducing the yields.

This, in turn, pushed borrowing costs lower, meaning people and companies could afford to borrow more money. This process went on until mid-2014.

In 2010, the Bank of England started a smaller version of QE, followed by the Bank of Japan in 2012 and the European Central Bank in March 2015.

So, we now had US$15 trillion worth of QE pumped into global bond markets across all four central banks.

This led to some record-high bond prices and record-low interest rates.

Some European bonds are still offering investors a negative yield (return to maturity). This has dramatically increased the risks to people holding long-dated bonds.

What are returns now?

See below the net real return that an investor could get now by investing into a one-year bank term deposit, versus a one-year bond with a similar credit rating (Figure 1).

We use this as a comparison because they both have the same term to maturity, and a similar risk. The only difference is that one is a term deposit and the other is a bond.

The term deposit will provide a net real return (after tax and inflation) of 0.86 per cent, versus the bond at -0.94 per cent.

How do rising interest rates affect bonds?

Bonds with a fixed interest rate, known as a ‘coupon’, are affected by changes in the market interest rates.

For example, if you owned a bond with a 3 per cent interest rate, and the underlying market interest rate rises to 5 per cent, your bond becomes less attractive, and its price will go down.

The reverse happens if interest rates move lower – the bond value increases.

The length of time until the bond matures also affects the price. The longer before it matures, the more sensitive the bond will be to interest-rate movements on its price.

For example, a 10-year bond could lose up to 10 per cent of the original purchase price if the underlying 10-year yield moved up just 1 per cent from when the bond was purchased.

Why does this matter?

On 31 August, the Bloomberg Barclays Global Aggregate Bond index had just over 22,400 bonds globally, with a duration (average maturity of all the bonds) of seven years. Gross yield was just 2.55 per cent a year.

Not much of a return

After allowing for tax, hedging, fund manager costs, adviser fees, and inflation, New Zealand investors might be very surprised at how little’s left over for them in returns.

If global interest rates fall from their (already very low) current levels, an international bond fund like this might see a capital increase. But if global interest rates rise instead, the fund could suffer a capital loss.

Now’s a good time to review the income part of your portfolio to confirm what the average yield (return to maturity), credit rating, and duration (term to maturity) is.

If you believe interest rates could rise, then you will want to have a very short duration. In most cases you might find term deposits a better option but, at the very least, you should know what your hard-earned money is invested in. 

Definitions

Bond: A bond is a fixed-income investment where an investor loans money to a body (typically councils or the government) for a time frame for an interest rate.

Bond yield: Yield is the money you make when a bond has reached maturity. It includes the price you paid for the bond, and the interest rate you receive.

Hedging: Hedging is an action where the fund manager removes the risk of an impact on performance from the NZ dollar movement in value against other currencies.

Quantitative easing: A monetary policy used by central banks and governments to stimulate their economy, often through the purchase of government bonds and increase in the supply of money.

Term deposit: This is a fixed-term deposit, held at a bank or similar.

First published 28 February 2019

This article does not contain any financial advice and has not taken into account any particular person’s circumstances. Before relying on it, we recommend you speak with a financial adviser.  This story reflects the views of the contributor only. Content comes from sources that we consider are accurate, but we do not guarantee that the content is accurate.


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