The Financial Markets Authority (FMA), conducts an annual Survey into the level of confidence New Zealanders have about financial markets.
The latest survey indicates that New Zealanders are not well informed about one of the world’s largest financial markets – the bond market. This is despite the fact the size of the worldwide bond market (total debt outstanding) at 2017, was estimated by the Securities Industry and Financial Markets Association (SIFMA) to be US$100 trillion. By contrast the worldwide share market was estimated at US$85.3 trillion.
For example the survey reported that only 55% of participants considered corporate/government bond investments to be low risk.
The bond market does not get nearly as much attention among investors as the stock market probably because share investments can skyrocket in value but are also more likely to suffer pronounced falls due to specific events and changes in economic conditions.
In addition the bond market can be confusing for even experienced investors and so perhaps it is not surprising that the public can be ill-informed.
What are Bonds
The bond market is a financial market where participants can issue new debt in the so-called primary market, or buy and sell debt securities in the secondary market. In this sense bond markets are similar to share markets as both operate within primary and secondary markets.
However unlike shares, a bond is a form of loan where investors lend to borrowers such as Governments, local authorities for example the Auckland Council, or corporates such as Banks and larger companies that want to borrow. The borrowers will use the funds for a variety of purposes including to build infrastructure, implement their policies, expand their businesses and diversify their sources of funds.
Bonds can be thought of as an IOU where the borrower agrees to repay the investor on a future date and in the interim pays a fixed or contractual income typically set as a fixed rate or a variable rate of interest expressed as a margin over an established benchmark.
Since investors in bonds know when the bond will be repaid and when and how much interest will be paid through to maturity date, it follows that bonds are considered to be much lower risk than share investments. Companies that issue shares typically have no contractual obligation to pay dividends or to return principal to the investor.
It might seem as if bonds are equivalent to term deposits placed with banks. They are both income generating assets and if repaid on due date by the borrower there is no capital gain or loss.
However key differences are that:
· Bonds are issued by a wide variety of borrowers and therefore provide investors with plenty of choice as distinct from simply depositing your funds with the bank.
· As set out above, bonds can be sold in secondary markets prior to maturity and therefore have a tradable price and are generally more liquid i.e. can be sold if a cash need arises.
What Factors Impact on Bond Prices
Although bonds are generally low risk, they do have varying degrees of risk and this impacts on their price.
Interest Rate Risk
Bonds are exposed to interest rate risk. If general market interest rates rise, the price of bonds that are paying a fixed rate of interest will fall. This is because investors can buy newly issued bonds earning higher interest rates and therefore there will be less demand for the existing bonds and their price will fall. Prices should fall to the point where the existing bonds can be purchased at prices that offer a similar overall return to the buyer, as they would achieve by purchasing a new bond.
Conversely if general interest rates fall, the price of existing bonds will rise because there will be more demand for these bonds paying a contractually higher rate of interest. Prices will rise to the point where a new buyer will achieve a similar overall return as they would achieve if they purchased a new bond.
Accordingly bond prices vary inversely to the movement in market interest rates.
However as long as there is a high likelihood that the bond issuer will make principal and interest payments as contracted, interest rate risk is temporary. Ultimately interest and principal repayments made on time and in accordance with the contractual amounts will result in investor returns as per the originally agreed fixed or contractual rate.
Credit Risk
This is the risk that the principal and interest repayments will either be delayed or will not be fully honoured. In this case the price of a bond will decline to a price that reflects the reduction in interest income and in the amount of principal that can be recovered.
Bond issues are typically given credit ratings by rating agencies such as Standard and Poor’s (S&P). Higher ratings are assigned to bonds that are assessed to have a low likelihood of default with AAA the highest rating. Ratings of AA, A, BBB, BB etc down to D represent decreasing credit quality.
Higher rated bonds pay lower interest rates than lower quality bonds because investors demand a higher return for investing in lower quality.
Implications for Investors
· Bonds offer regular interest income but they do not offer upside when held to maturity because investors are only entitled to repayment of the principal. Share investors have upside potential but apart from temporary price movements bond investors do not.
· Bond investors are able to enforce their contractual right to interest and principal and have priority over shareholders for receipt of any payments arising from enforcement of these rights. It follows that if a company gets into difficulty the bondholders will be relatively better off than the shareholders who will bear the brunt of any losses that arise.
· Shareholders face steep losses at times but also have the opportunity to enjoy large gains when the company does well. Bondholders have lower risk but lower potential returns due to the lack of upside.
· There is little incentive to invest a large amount of money in a single bond because there is low potential upside (whereas a share investor may profit handsomely from a concentrated portfolio of highly performing shares). Conversely there is a strong incentive to hold a very diversified exposure to bonds because if losses happen to individual bonds the exposure is small.
The Role of Bonds for Investors
The primary role of bonds is to reduce overall portfolio volatility and to provide liquidity and cash flow.
Portfolio Volatility and Capital Preservation
The recommended proportion of bonds within a portfolio varies depending on the risk profile of the investor. Conservative investors that are concerned to ensure capital stability may have upwards of 80% of their funds invested in income assets such as bonds and cash with only 20% in growth assets such as shares and property. Conservative investors will typically earn lower but more stable returns over time.
Growth investors will have a greater weighting towards shares and property say 80% with only 20% invested in bonds and cash. Growth investors should enjoy higher returns over time but with greater volatility due to the higher weighting towards riskier assets.
Balanced investors might have a weighting of 50% income assets and 50% growth assets.
Bonds therefore provide ballast to investment returns. A prime illustration of how this may occur in practice is to consider the role that policymakers such as central banks and governments play during economic downturns. In order to stimulate demand these agencies seek to reduce interest rates.
As explained above, when interest rates fall the prices of existing bonds rise rewarding bond investors and offsetting the likely losses for investors in growth assets where prices are depressed due to the economic slowdown.
Another common illustration is where investors are spooked by adverse events such as trade wars, oil shocks and real wars. In theses cases there is a “flight to safety” as investors abandon growth assets and crowd into the safety of high quality bonds such as government bonds. Shares and other growth assets that are being ditched fall in price, but the price of the bonds rise due to greater demand.
At the extreme, where an enterprise fails completely, its remaining assets will be disposed and the bondholders will be paid out from the proceeds in priority to the shareholders. The bondholders (and other priority creditors such as employees and Inland Revenue), have a much greater prospect of getting back the sums due to them.
Investors that have shorter investment horizons and have earmarked their funds for a future endeavour such as buying a house or a business, or who value stability of returns and capital preservation should have a higher fixed income allocation.
Income
Bonds are designed to provide reliable income over time. Bond issuers are contractually obliged to pay interest whereas there is no obligation for companies to pay dividends nor is there a guarantee that an investment property will be fully tenanted. Therefore investors that require a regular income, for example retired investors, will want a greater allocation of bonds in their portfolio.
They could of course create income by, for example, selling some of their shares but as already explained there is a risk they sell the shares during a downturn when the share price is temporarily depressed.
Low and Negative Returns
Interest rates on bonds and on other income investments such as cash, term deposits, and debentures have progressively dropped over the last 35 years to the point where some commentators are now saying that interest rates are at 1,000 year lows.
Ten year Government bonds issued by a number of major economies such as Germany, France, Switzerland and Japan are now trading at prices that provide negative returns to investors holding them to maturity.
In these and in other advanced countries such as Denmark, depositors may be “penalized” for depositing money with their banks – they might for example deposit $1 and in accordance with the agreed rate get back $0.99 at maturity.
It appears that we are in a global environment of high productivity and surplus capacity caused by rapidly advancing technology. However in many advanced economies there is lower economic demand perhaps due to aging populations, political uncertainty such as Brexit, the breakdown of rules based global order, changing primacy in global leadership between the US and China, trade wars and global warming.
These two forces of over-supply and anemic demand have lead to very low inflation and in some countries such as Japan to deflation – i.e. where prices are falling. In this situation individuals and companies placing money in the bank at negative interest rates or investing in bonds paying a negative return may still be better off in real terms because goods and services that could be acquired for $1 today might only cost $0.98 in one years time.
Following the global financial crisis, the response of central banks and governments to recessionary conditions in a number of these advanced economies including the US as well as in Europe and Japan has been to implement a form of expansionary monetary policy known as quantitative easing. Quantitative easing involves central banks buying large amounts of government bonds and other securities, driving up the price of these securities and driving down returns in some cases into negative territory. Retail and wholesale banks can no longer earn acceptable returns from investing their reserves into these securities and they are forced to seek higher returns by lending a greater proportion of their available funds to individuals and commercial enterprises at interest rates that are sufficiently low to encourage them to borrow, spend and invest.
The jury is out as to whether quantitative easing has achieved its original goal to stimulate demand and avoid all out recession, however it is one of the root contributors to low global interest rates exacerbating the underlying causes described above.
Fortunately global fixed income capital markets are extremely large and diversified. There are a vast number of investments that offer low but acceptable returns and enable investors to maintain defensive portfolios and reasonable income levels.
Danger Signs for all Investors
Interest rates are at unprecedented low levels and this spells danger for investors who may:
· Become over-exposed to shares and property due to low fixed income returns.
· Seek out higher returns from low grade bonds issued by less credit worthy borrowers or with disadvantageous terms such as the inability to enforce a default in the event of a failure by the borrower to honour interest due dates. Yes these securities are traded in the New Zealand market!
· Seek higher returns from investing in bonds with longer dated maturities e.g. 10 or 20 years. These have higher interest rate risk and will suffer capital loss if interest rates start rising to “normal” levels.
· Become over exposed to one borrower – even government borrowers can default on their obligations and bond investors have no upside beyond their principal and interest entitlement.
· Failure to diversify internationally and becoming over-exposed to the New Zealand market.
· Ignore alternatives such as floating rate and inflation-adjusted bonds or by not availing themselves of hedging tools such as the ability to short sell bonds (thereby profiting from rising interest rates and falling bond prices).
· Invest with fund managers following passive investment strategies – you will have a portfolio with high levels of interest rate risk and excessive concentration to over-indebted governments paying artificially low interest rates!
If you want to discuss these opportunities and avoid the pitfalls please call me for a no obligation chat.
My name is David Smart. I am an Authorised Financial Adviser. In providing financial advice, I review my client’s current financial situation, identify short, medium and long term goals and develop recommendations for meeting them.
The views expressed in this article are intended to be of a general nature and do not constitute personalised advice for an individual client.
