Here we look at fixed income investments – how they work and why returns have been so challenged recently
After two decades of cash (and interest) rates being lowered, the Reserve Bank of Australia (RBA) cut to a record low of 0.10% in November 2021. Because bond prices go up when interest rates go down, these lower rates have meant that holding bonds has been a boon for capital returns, even though income from the same bonds decreased dramatically.
Since mid-2022 however, central banks such as the RBA have changed course to stave off the threat of prolonged high inflation by raising official interest rate from these record lows and back to more historical levels. From a superannuation point of view, it is important that the RBA attempts to curb sustained high inflation, because inflation erodes superannuation savings and therefore erodes the purchasing power of your super balance (your “bang for your buck”) when it comes time to retire.
In the short term, rates increasing is a negative for bond holders (as new bonds will pay a higher interest rate, and income amount, than old bonds, so old bonds are now worth less in comparison). On the upside however, it also creates opportunities, because as income from bonds rises, so do future income returns and this gives some protection from the next economic downturn. The reason for this protection is that higher interest rates on bonds means more income each year, and this acts as a buffer against bond prices falling in the future - decreasing the chances of a negative total return.
Returns from bonds have been challenged recently as the low income available from bonds was not enough to counter the negative capital returns from the higher interest rates, and this led to total negative returns.
In a diversified super portfolio, higher income bonds usually provide a buffer for when growth assets (like shares) perform poorly during an economic downturn. The reason for this is that when rates are higher the RBA has more room to decrease rates, and stimulate the economy, which will mean the price (and therefore capital returns) from bonds will go up, and the income returns will still provide cashflow above the historical low levels.
Although these are long-term benefits and holding bonds and shares together provides good long-term diversification, we understand that this current period of volatility is concerning for our members, because equity and bond returns have both endured negative periods. It does not typically occur that shares and bonds both fall at the same time, but once inflation levels match what the RBA are comfortable with, then the volatility in bond markets will end and bonds can go back to being the low volatility defensive assets that make them such an important part of a diversified super portfolio.
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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 like 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.
They may be fixed income investments, but bond returns are not ‘fixed’
The original price of a bond, its coupon interest payments, maturity date, and price at maturity are fixed. But bonds can be traded in a large secondary market, so 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 coupons are fixed and can’t change, the market adjusts the price of the bond up or down.
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 also go up. 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)
Please note that past performance is not a reliable indicator of future performance and does not guarantee returns.
