Monday 10 November 2014 by Elizabeth Moran Education (basics)

Busting the seven key myths about bonds - Part 2

Over the last 15 years, the FIIG team has had thousands of conversations with investors who are considering investing in bonds and other fixed income investments.

We’ve come to recognise some key concerns that investors quote when discussing a potential investment, most of which are based on false assumptions. So, if you’re still unsure about bonds, this series of articles which delves into the “Seven Key Myths” may help.

Myth #2 It’s a bad idea to invest in bonds when interest rates or inflation are rising

Reality #2 The markets’ expectation of future interest rate rises are already built into the current price of fixed rate bonds and only fixed rate bonds (not floating rate or inflation linked) are directly impacted by a rise in interest rate expectations.

1. Markets are forward looking, so bond market prices have priced in expectations of future interest rate changes already

To assume that when the RBA or the US Fed increases interest rates, that it is bad for fixed rate bondholders is not necessarily true, and actually more than often wrong. Markets are forward looking, including both share markets and bond markets. We’ve all seen shares that have announced a loss, yet the share price went up because the market was expecting a worse loss than announced.

Bond markets are the same – if rates rise, but rise less than expected, bond prices will go up, not down. It is a rise in interest rate expectations that is bad for bondholders, and a fall in interest rate expectations that is good. As interest rate expectations fall when economic conditions surprise on the downside, the real question for bondholders is not whether rates are rising or falling (that’s already priced in to bond prices), but whether the market is more likely to be surprised on the upside or the downside given economic conditions.

2. Only Fixed Rate bonds are directly impacted by a rise in interest rate expectations

There are three different types of bonds (fixed rate, floating rate and inflation linked) that work to protect your portfolio in various ways and are most effective under different market conditions.

Fixed rate bonds pay a fixed pre-determined rate of interest or coupon which is set at the time of issue and does not change during the life of the bond. These investments are ideal when the economy contracts (when property and shares usually underperform) and interest rate expectations move lower. The difference between fixed rate bonds and term deposits is that because the bonds are tradeable, their price moves.

A floating rate note (FRN) pays a set margin over a variable benchmark and in Australia the benchmark is usually the bank bill swap rate (BBSW). The underlying benchmark rate will rise and fall over time based on prevailing interest rates. The margin over the benchmark is usually fixed and will be set at the time of issue.

Floating rate notes, because of the way they are structured, typically protect a portfolio when interest rates are rising. That is, as the Reserve Bank increases the cash rate to try and slow growth in an economy, FRN interest payments will also increase. Therefore, FRNs typically outperform fixed rate investments such as term deposits and fixed rate bonds when interest rates are moving higher. FRNs are also more capital stable than fixed rate bonds, in that their prices do not move up and down to the same extent.

Assuming a company survives, whatever happens to the price of a bond over its term, investors would still expect to be repaid the face value (the value at first issue) which in most cases is $100.

The third type of bond is an inflation linked bond (ILB) which is the only security that provides a direct hedge against inflation. Capital is indexed to the Consumer Price Index (CPI). Interest payments are based on the capital value, so assuming inflation is positive, the capital value will increase and the interest payments would also increase over the life of the bond.

Inflation linked bonds can be attractive in low interest rate markets. The bond prices can be lower than the value of the bonds.

In summary, the three types of bonds work best in different economic conditions but for investors new to fixed income, we would recommend a portfolio allocation to all three although weighted depending on your interest rate outlook.

As a final point regarding the direction of bond prices, a word of warning: the experts have been getting it wrong every year for the past six years. Barron’s Big Money Poll is a survey of some of the US’s largest fund managers. We looked at their forecasts for the US 10 year Treasury Bond yield and compared them to the actual result. What it shows is that you could be well placed to ignore the experts and ensure you are covered in every eventuality.

Barron's big money poll prediction dates

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