50% more return from fixed interest
When we buy a “deposit”, we buy the interest rate of the day. Today, if we buy a one-year deposit, we’ll get around 5%pa. If we take a five-year deposit, it’s around 4.5%pa. (The yield curve is currently inverted; that means investors get more reward for being shorter term, than being longer term). In practice, most investors will tend toward a one-year deposit and see how things are in a years’ time.
Say in 12 months, the one-year rate is 4.25% (a very real possibility as we write today). Our renewal option for another year is therefore 0.75% lower. Over that following year, interest rates continue to fall and the next roll-over rate is 3.5%. A year later, it’s down to 3%, where it remains for another two years.
So over five years, the interest being generated has fallen 40% (from 5% to 3%pa). We’ve ridden the wave lower, but could we have done better?
Some people see interest rates falling and look to lock-in for longer (think of a fixed mortgage strategy, but in reverse). If we lock in a 5-year deposit at 4.5%pa today, this is the rate we’ll get until maturity. But what happens if we need that money before 5 years’ time? Locking in seems a big risk… What if rates rise? But what if rates fall? Risk persists no matter which option.
This is where Bonds can pay off (over Term Deposits). Bonds can be bought or sold anytime, in whole or part. When underlying interest rates in the market fall, the return on “long-dated” bonds will rise because, whoever then owns the bond gets the higher interest it continues to pay (the higher interest, has greater value).
Broadly, if interest rates fall by one quarter of one percent (0.25%), then a bonds value amplifies by every year of duration remaining; ie. if a bond has four years remaining before it matures, and interest rates fall 0.25%, its value rises 1% (0.25% x 4 = 1%). If interest rates over the next year fall say 0.75% (as implied), and this bond has four years remaining (maturity), then its value is amplified by 3% (0.75% x 4).
Say we invest $100,000 into a bond paying a coupon of 4.5%pa for 5 years. Interest rates then fall 0.75% to 3.75%. We then decide to sell our bond. Using the above rule of thumb, we’d get roughly $3,000 more than we expected. How come? Well, when we bought the bond, we were locking in 4.5%pa for the duration. Due to interest rates having moved lower, the new owner buys the extra interest this bond is paying above the now lower market rate. Our 3% windfall is due to the interest difference and the duration remaining. So, in this first year we are delivered a return of 4.5% (original interest agreed) plus the 3% gain - giving 7.5% for the year. At the start of the year, we could have locked in a Term Deposit at 5%.
Our return on investment is 50% more than the TD (7.5% is 50% greater than 5%). But remember, this is only a moment in time. Interest rates will keep moving. If we get the trajectory wrong and rates rise, then value can equally be lost. In that instance, we may simply decide to hold to maturity for the principal guaranteed to return and we’d earn the 4.5%pa (which was the rate we locked in at the start).
Wins or losses only occur when we sell, everything else is “paper” value. This risk is reflected daily in share and property markets. Losses on paper occur all the time and yesterdays’ loss is often eased by today’s gain. Avoid realising losses wherever possible! Investing is easy - it’s just not always simple.
Ultimately, direct bonds and bond funds are intended to be conservative (low risk) and so, it’s hard to fathom that they can from time to time be this volatile and deliver such extremes. Fixed Interest is seldom actually fixed. Be aware, bond funds don’t have specific maturity dates. A bond fund is perpetual, and each has a specific intention around credit risk and duration. So, we need to be alert to what the risks are and always take a portfolio approach to managing the low-risk parts of a total strategy.
In that regard, today it seems for many the writing is on the wall, that the pressure in the economy both here and abroad is such that interest rates are likely to keep driving lower and if that is the case, then having some longer-term duration “safe” assets in your strategy should pay off in the short-term.
The views and opinions expressed in this article are intended to be of a general nature and do not constitute personalised advice for an individual client.
