In this blog we provide an overview of how interest rates can impact our fixed income returns, and why returns have been challenged recently.

A challenging environment for fixed income returns

 

Over the last two years the COVID pandemic has significantly impacted global bond markets and bond returns. In early 2020 as the pandemic hit and economies stalled, interest rates dropped and in turn bond prices climbed. In 2021 however, with the rollout of vaccines, economic recovery, and higher inflation expectations, we saw bond prices (and therefore returns) drop.

The increase in bond prices had a positive impact on the performance of fixed income investments in early 2020. But since then, on growing expectations of interest rate rises and economic recovery, fixed interest investments have had periods of lost value. Higher coupons offered on new bond issuances have resulted in lower prices for previously held bonds and thus negative/lower returns on fixed interest investments.

Our fixed interest investments have not been immune to these dynamics. For our fixed interest options there have been periods of negative returns, including a negative return for the calendar year 2021.

We explain below what fixed interest investments are, and why returns go up and down.

 

What are fixed income investments?

 

Fixed Income investments such as bonds operate like a loan contract between two parties - a lender and a borrower (called an issuer). In this way they’re similar to your home mortgage, with the bank being the lender (investor) and you the borrower. A bond issuer (borrower) can be a government (such as the Australian Government) or semi-government body (such as the NSW Treasury), or a corporation (such as ANZ or Amazon). Bonds are issued to raise money for the borrower (this can be for a variety of reasons such as investing in infrastructure or paying public service wages, for example).

Bonds as an investment, though, are held by the lender. They work by lending a lump sum of money to the borrower in exchange for regular fixed interest payments called coupons over the loan period, plus a repayment of the loan amount (principal) upon maturity of the bond.

A bond can be invested in by taking part in a new issuance direct from the borrower, or on the secondary market from another lender. The riskier the lender and loan period, the higher the interest amounts they will pay to investors.

 

A bond return is not ‘fixed’

 

The original price of a bond, its coupon interest payments, maturity date, and price at maturity are fixed. But the bond price in between these periods can go up and down. This fluctuation can be due to many reasons – including a change in future interest rate expectations or events surrounding the individual lender. Since bonds cannot change their coupons to align with new coupon sizes (as coupons are fixed), the market adjusts their price so their future returns can match them instead.

Let’s look at an example of this in action. As interest rate forecasts go up, the fixed interest payments (coupons) available on new bonds are also higher. Bonds we already own are now worth less because their coupon interest payment are lower than those of the new bonds. But, if interest rate expectations go down, the opposite is true and all else being equal, bond returns will rise.

Changes affecting bond prices:

  • interest rate and inflation forecasts (related to coupon size and time to maturity)
  • risk associated with the individual lender
  • economic and market conditions
  • market and individual bond liquidity (how many buyers and sellers there are)

 

Fixed income plays an important role in a diversified portfolio

 

Fixed income plays a very important role in a well-diversified portfolio because it provides diversification, capital preservation (both of which ‘smooth’ out returns), as well as regular income cash flows and liquidity benefits.

Super is a long-term investment, so it’s important to have a well-diversified portfolio with high quality assets to help ride out the inevitable market ups and downs. That’s where our diversified options and lifestyle strategies come in - or you can choose from a mix of our single asset class options or a blend of both.

You should consider factors such as your age and retirement goals when making an investment decision. If you are unsure which option is right for you, learn how you can get simple advice at no extra cost.

Please note that past performance is not a reliable indicator of future performance and does not guarantee returns.