The need for balance
Fixed interest or bond investments don't capture the investing public's imagination like shares. If it did last year's bond market crash could be described as one of the biggest bloodbaths for someti.
Tuesday, February 29th 2000, 12:00AM
It would be akin to a reasonable major sharemarket crash.
All bar one of the major bond markets around the world reported losses during the 12 months ending December 31. The big United States market for instance turned in a 6.44 per cent loss for the year, while the New Zealand market was down. The only country to escape the carnage was Japan.
The culprit for the continuing bond crash is rising interest rates. Central banks around the world, including our own Reserve Bank, hiked short term interest rates up to slow economies down, thus reducing the capital value of bonds.
The irony of this situation is that although fixed interest doesn't have the sex appeal of shares, it is a major component of a properly investment diversified portfolio.
While the younger and more aggressive investor is likely to have very few bonds, someone who fits into what is called a medium risk portfolio could be expected to have about a quarter of their assets invested in fixed interest.
Many older investors with a conservative portfolio could have more than half their money invested in fixed interest.
To many people (except those who owned fixed interest securities during the last bond crash in 1994) the idea of bonds making a loss is something which just doesn't compute.
On the outside a bond seems like a bank deposit where an amount of money is lent and the borrower pays a fixed rate of interest for a set period.
The difference with fixed interest securities is that they can be bought and sold at a market price. It is this market price which determines the actual value of a bond.
This market price is determined by the fixed interest rate on the security owned, relative to what the interest rate on a new security is.
It works like this. Say an investor pays $1000 for a fixed interest security with a three year term paying 6 per cent annually, then they would receive an interest payment of $60 annually and would get the principal of $1000 back at the end of the term.
But, say interest rates rose to 7 per cent a new security would pay $70 in interest each year.
If you wanted to sell the 6 per cent security in this environment, no one will pay $1000 for the security as they can get a better deal elsewhere. To sell the security its price has to be changed so that the $60 annual interest payment is equivalent to the market rate of 7 per cent. In this case the value of the security would be worth about $996.
The rising global interest rate environment makes it a wise time for investors to reconsider their strategies. To do this they need to consider how rising interest rates impact on other investments and assets classes, plus they need to look ahead and have an understanding of why rates are rising and how high they are likely to go.
When reviewing an investment strategy investors need to know rising interest rates have different impacts on various asset classes (which are outlined below). While bonds are being battered cash is on a comeback.
Cash - People with cash in the bank or term deposits are relieved to see rates rise as it increases their level of income.
Mortgage trusts - Mortgage rates rise in tandem with interest rates, so the follow on effect for these funds is positive, however investors need to be aware that there is a lag time between when rates rise and when the increased mortgage rates are passed on to borrowers.
Property trusts - Not a great place to be while rates go up. Currently listed property trusts are paying good yields, but the capital value of the assets is being eroded. The majority of listed property trusts in New Zealand are currently trading at significant discounts to net asset value.
Bonds - Putting money into fixed interest investments in the past 12 months is a kin to a "Tainui" investment strategy - investments lose money. However, when rates near their peak investors will benefit from any rally (interest rate falls). The issue with this asset class is picking the peak.
Equities - Traditionally when interest rates rise, shares go down. However, in the current environment rising interest rates have had only a minor impact on world bourses.
One key thing people need understand in this decision-making process is the relationship between fixed interest and shares.
The two are inversely rated, a bit like a see saw. As one goes up the other goes down. As this happens there comes a point where investors consider it better to make a switch from equities to bonds.
New York-based Ryan Labs director Ron Ryan says the whole thrust of the United States Federal Reserve's moves to increase the official short term interest rates are to encourage an asset allocation shift from shares to bonds.
He says that according to valuation models constructed by the Federal Reserve (the equivalent of our Reserve Bank) shares in the United States are up to 60 per cent overvalued.
The idea is that "if you can get interest rates high enough, especially in the short end (of the yield curve) people will make an asset allocation shift."
Ryan says the Federal Reserve is "trying to get the sharemarket to correct itself in a slow, progressive way so there's no dramatic impact to the economy."
From a strategic point of view investors have to make a decision on when interest rates will peak, as this turning point is where the capital losses are made into gains.
Economics New Zealand managing director Donal Curtin says the short-term outlook for fixed interest is "deteriorating" as rates will continue to rise.
The general consensus is that the Reserve Bank will hike short term rates another 50 basis points this year, and Federal Reserve chairman Alan Greenspan said yesterday that short term rates in the United States are likely to rise further.
Curtin is on the optimistic side of the predictions. He says the market seems spooked by further "on-going and vigorous" interest rate rises.
"I don't think (that view) is warranted," he says. "Rises will be gradual and modest, rather than sharp."
Continuing with the positive theme Curtin says that "two thirds of the global monetary policy tightening is behind us."
That means that the fixed interest market is nearing a more positive environment, including a future rally.
Curtin says considering the changes in the economy and the fact that no one knows when interest rates will peak it is sensible to make adjustments.
ASB Bank chief manager investment services Roger Perry says investors who have lost money in fixed interest investments over the past year need to review their reason for investing before making change to their portfolio.
"If your goal is something other than capital growth (for example regular income), then you may need to consider other alternatives."
Also, investors need to consider the loss against their time horizon.
"If you need access to most of your money within two years, then an investment with greater capital security may be more appropriate," Perry says.
Thirdly, a review of your risk profile needs to be made.
"Even conservative investments structured for three to five years and longer will occasionally lose value. If this makes you uncomfortable, you may be better placed in an investment with a stable capital value," Perry says.
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