Market Wrap | 15.11.13

In finance, a fixed rate bond is a type of debt instrument bond with a fixed coupon (interest) rate. A fixed rate bond is a long term debt paper that carries a predetermined interest rate. The interest rate is known as coupon rate and interest is payable at specified dates before bond maturity. Due to the fixed coupon, the market value of a fixed-rate bond is susceptible to fluctuations in interest rates. (Think of these as a term deposit offered by a Government or corporation).

For Long-term Investors, Rising Rates Are Nothing to Fear

What's going to happen to bonds - particularly the core, quality-oriented securities that anchor many portfolios - when rates rise? 

Most investors are familiar with the bond "seesaw" showing the inverse relationship between bond prices and yields. While the two are obviously interdependent, the reality for investors is more nuanced. In fact, despite the potential for short-term discomfort, rising rates should be welcomed by long-term investors, particularly in this era of historically low yields. This is due to the fact that interest income is the primary driver of bond returns, and the ability to reinvest into a gradually rising rate environment can actually increase returns, helping to build wealth over time. In other words, by reinvesting the income and proceeds of your maturing bonds in securities that pay a higher coupon, you are increasing the income you receive, and your future growth potential. (It should be noted that this benefit doesn't extend to equities. Rising rates increase corporate borrowing costs, putting pressure on both profits and the stock price.)

This leads to the mathematical truth that if you are a long-term investor, you should be hoping for rates to rise gradually from the current low rates, as your long-term returns will likely be higher, not lower.

The worst-case is not so bad   

Even at their most turbulent, bond prices are nowhere near as "bubbly" as stock prices - neither on the upside nor the downside. As a result, core bond declines have typically been much less severe and quicker to recover. Consider these "worst-case" scenarios: The sharpest calendar-year price drop for U.S. bonds was 3%, in 1994. Meanwhile, stocks, as we well recall, had their worst year in 2008, sinking 38% - a significant decline in wealth that can be difficult to recover for those close to retirement. Bonds' relative steadiness is one of the primary reasons investors have relied on fixed income to anchor their portfolios.

"Carry" on, beyond duration
Today's "market of bonds" is undergoing a sea change, one in which investors will need to de-emphasise duration and tap into other sources of value to boost their portfolios' return potential. These diverse forms of yield, or "carry" - which include premiums earned from credit quality, yield curve roll down and currency exposure, among other risk factors - will be increasingly important tools for fixed income managers as they nimbly work to adapt to and profit from today's evolving rate environment.  

Indices:

The Australian All Ordinaries Index has moved down decreasing by -0.4% since closing last Friday to 11:00 am today.

                                                                                                                                  

The rest of the world as measured by the MSCI index increased +5.8% in A$ from closing last Friday to end of trade Thursday.

Have a great weekend,

The team at IPS