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Tougher times for Fixed Interest

Most investors know that the four major classes of investment assets are cash, fixed interest, property and shares. Typically in a fully diversified investment portfolio cash and property (such as listed property trusts) usually account for a much lesser proportion than fixed interest and shares.

Many advisers such as us break fixed interest investments into “secure” (high quality) or “risky”. Risky fixed interest is generally lower quality non-investment grade, or it could include “perpetuals” or “resets”. They can be considered as risky, as they tend to behave price wise in a manner similar to shares.

Fixed interest investments, such as term deposits, directly held bonds or bond funds, provide stability and income to a portfolio, while shares provide growth, albeit with volatility. That is fine in a “normal” investment environment. An investment environment where several large economies (UK, USA, Japan) have embarked on quantitative easing (QE or printing money) is hardly normal.

QE appears to have been most successful in the United States and this seems to have diverted the global financial crisis from what would have been a depression to a recession, and then out to positive economic growth. During the period of QE, bond values increased as the Fed bought billions of dollars worth driving the yields down.

Several weeks ago the Fed announced that they were going to taper off the purchasing program. Once the announcement was made, longer dated US Treasuries (“government bonds”) yields increased, driving the value of bonds down. This has impacted on bond yields in other countries including New Zealand.

Two million or so New Zealanders will most likely have been impacted by this in their KiwiSaver accounts and in other diversified portfolios. Effectively there was little that the various fund managers could do, because their investment mandates dictate what investments they can have. Those mandates which allow shorter duration fixed interest should have fared better than those whose mandate benchmark was for example the government stock index.

Bond yield increases (effectively meaning a fall in market value of the asset) look to be a fact of life in the investment world for some time to come. Most of the increases will be seen in longer duration bonds, as it looks like short term interest rate rises will be strongly influenced by the rate that the Governor of the Reserve Bank increases the official cash rate. The real question mark around bond funds is will the yield increase decrease the value of the investor’s holding. At yields prior to the Fed announcement, a yield increase of around 75 bp will negate the overall return of the investment. The yield increase spiked above that late in the past quarter, hence the overall performance of many bond funds for the past year will be close to zero, and in some cases below zero.

So what can investors do? One method is to reduce exposure to bond funds and reinvest the proceeds into for example a short term TD. Once bond yields have risen, they could then buy back into bond funds with the proceeds. Unfortunately, if you are invested in a Master Fund, or indeed a KiwiSaver fund it is unlikely that this option is available to you or your adviser. Our pick for the next fad investment will be “absolute return fixed interest funds”. Claims will be made that they can make money irrespective of the markets. Whether that means they will make money for the investors could be another story. Time will tell.

Disclaimer

Steven Barton (FSP 32663) and Susan Pascoe Barton (FSP 32382) are Certified Financial Planners and Authorised Financial Advisers.  Their initial disclosure statements are available free of charge by contacting them on (07) 3060080 or they can be downloaded from www.pascoebarton.co.nz. This column is general in nature and should not be regarded as personalised investment advice.