Part one of a three part series. Combined, the articles explain that bonds are appropriate investments across all economic cycles
There are three different bonds that work best under different economic conditions:
- Fixed rate
- Floating rate
- Inflation linked
It is important to hold an allocation to all three bonds for protection, as investors can never be sure that interest rates will not move higher or lower or inflation spirals. However, the portfolio weighting may change depending on the investor’s view of interest rates.
Ideally investors should read all three articles to understand the characteristics of the bonds and how they might work in an investment portfolio.
A fixed rate bond is a security that pays a fixed pre-determined rate of interest (known as a coupon). A fixed rate bond’s interest rate will be set at the time of issue and will not change during the life of the bond.
Fixed rate bonds add interest rate “risk” to your portfolio in that the only way these bonds can reflect changes in market expectations of interest rates is through a change in the price of the bond. If interest rates fall, fixed rate bond prices will rise. The opposite is also true, if interest rates rise, fixed rate bond prices will fall.
In the example below, assume an investor purchases a ten year fixed rate bond worth $100 at an interest rate of 5%. Fixed rate bonds will pay the same rate of interest for the life of the bond. If interest rates then rise to 6% from 5%, investors in the secondary market are not willing to outlay $100 to earn a 5% return. They demand a 6% return in line with market expectations. To achieve a 6% return the price of the bond must fall to $92.561 to satisfy the 6% required rate. Likewise if interest rates fall to 4% investors are willing to pay more for the bond and the bond price will rise to $108.176.
These bonds are particularly protective in an overall investment portfolio as they outperform in a contracting economic environment when you would expect declining share and property prices. That is, fixed rate bonds tend to be counter-cyclical. When the Reserve Bank is easing the cash rate (to try and stimulate the economy) fixed rate bond prices typically rise. So a fixed rate bond allocation will act to smooth overall portfolio returns, as shown in the graph below which compares the performance of the All Ordinaries Accumulation Index (the blue line) and the UBS Fixed Rate Bond Index (the grey line). Note the low points of the equity index versus the increase in return of the fixed rate bond index. Equities returns are more volatile, that is show greater variability in return.
The prices of fixed rate bonds can vary considerably. For example in 25 November 2010 Stockland issued a fixed rate bond with at an 8.25% fixed interest rate. Since then, the cash rate has declined and the bond’s price has risen to be $123.859 (pricing accurate at 17 February 2015). Investors who had bought the Stockland bond at first issue could sell the bond and take a higher than expected return or otherwise continue to hold the bond and enjoy the high income stream.
Bond prices can also fall below their $100 issue price, but investors know when they buy a bond, assuming the company continues to operate, if they hold that bond until maturity, they will receive $100 face value.
Fixed rate bonds can be attractive investments in a low interest environment. As returns are fixed, those bonds issued with high interest rates will pay a high, defined income stream which is attractive to income seeking investors.
The Commonwealth government, state governments, public and private corporations (both domestic and international) all issue fixed rate bonds in Australia.
An example of a fixed rate bond is the Dalrymple Bay Coal Terminal 6.25% bond maturing on 9 June 2016. Assuming a $100,000 face value investment, this bond pays a half yearly interest payment (like most fixed rate bonds) of $3,125. In the month that the bond matures, investors receive the $3,125 interest payment as well as the return of the $100,000 face value investment.