Tuesday 11 July 2017 by FIIG Securities lizNZ Opinion

What happens to bonds when interest rates rise?

As published in The Australian on 11 July 2017

There are winners and losers when interest rates rise. Investors prefer floating rate notes as interest is adjusted quarterly. Longer dated fixed rate bonds are less attractive

Boat in Milford Sound

Central bankers are talking up the possibility of interest rate rises. When interest rates are rising, it’s generally a sign of a growing economy, nearer to full employment and rising inflation. Consequently, central banks raise interest rates to dampen growth by making it more expensive to borrow. As bonds are loans, if interest rates rise, the cost to borrow rises for governments and companies.

Those with savings will be happy to see rising interest rates as they can earn more. Picture yourself as a retiree, with one third of your savings in a term deposit earning 2.6 per cent per annum. Say interest rates move up by 1 per cent and you can now get 3.6 per cent per annum.

Assuming average dividend yields of 4.5 per cent per annum stay constant then the term deposit option just got a whole lot more attractive. In a rising interest rate environment, we’d expect funds to shift from shares and property and into fixed income options like deposits and bonds as they become relatively more attractive. Higher borrowing costs can lower company profits.

Immediate affects

Bonds are priced on interest rate expectations, not necessarily actual interest rate increases. The market just has to think interest rates might rise and we see benchmark rates, such as the 10 year government bond rate and the bank bill swap rate (BBSW) rise.

Take the last US interest rate hike in June; it was so well flagged that markets had already factored in the move before it occurred, so that when it actually happened there was little change.

Looking back at the last rising interest rate environment in Australia, in September 2009, benchmark 3 and 10 year bond yields predicted the rise at least six months before the RBA increased the cash rate. In fact, both benchmarks rose steeply from around three per cent to five per cent before the cash rate had moved at all – the reason why so many experts watch government bond yields even if they don’t invest. 

Source: Bloomberg, FIIG Securities

If there was a surprise hike, bonds already trading in the secondary market would see prices adjust depending on the type of bond.

Fixed rate bonds would be hit the hardest. These bonds pay a fixed rate when first issued that cannot change over the life of the bond.

For example, there is a Stockland bond on issue paying 8.25 per cent per annum or 4.125 per cent each half year per $100 of face value. Since that bond was issued quite some time ago, interest rates have come down and the only way the bond can reflect changing interest rates is through its price. It is now trading at around $117, $17 above its face value of $100. New investors would pay $117 and the effective yield if the bond is held to maturity is about 2.9 per cent per annum.

The price of the Stockland bond would be expected to drop as investors demand more than 2.9 per cent for investing, and the rise in yield would not be good for investors that recently purchased the security, but would be more attractive to prospective investors and neutral for those that have a buy and hold to maturity approach.

Longer dated fixed rate government bonds would be very sensitive to rising interest rates and we’ve seen some sharp moves in prices and yields over the last four months, great for bond traders.

Floating rate bonds would see negligible impact from an increase in rates, as interest is tied to a benchmark and adjusted quarterly. But, if a series of interest rate hikes were expected, we would expect demand for ‘floaters’ to rise, possibly pushing the prices up – a good outcome for existing investors, not so good for prospective investors and again neutral for those that hold to maturity.

Longer dated inflation linked bond prices would also likely decline as part of the return is from a small fixed rate of interest. However, any decline in price is likely to increase demand if interest rates were rising quickly to combat a spike in inflation.

Longer term impacts

There are a number of longer term factors if interest rates rise, both positive and negative:

  • Lower risk investments such as deposits and bonds become relatively more attractive to investors who don’t need to take on more risk to satisfy pre-determined notions of minimum required returns.
  • Companies and governments pay more to borrow, so perhaps seek alternatives, like selling assets, issuing equity or in a worst case scenario, deferring investment, contributing to lower economic growth.
  • Investors are offered higher returns, drawing funds from other asset classes, and for investors holding bonds near to the maturity date, they get to take advantage of higher rates on offer when it’s time to reinvest.
  • Bonds issued when interest rates are low, that have call dates where there is an option but not an obligation to redeem, may defer repayment – a negative for investors who would prefer to invest in newer securities with higher yields.
  • Governments with huge debt have to pay more interest.

Bond strategies in a rising interest rate environment

  1. Increase your allocation to floating rate bonds, where income is adjusted quarterly, so it only slightly lags the market.
  2. Invest in short dated fixed rate bonds, where you expect to have capital returned soon, so you can invest at the expected higher rates.
  3. Consider high yield bonds where much more of the reward is for the credit risk you are taking, rather than a more pure interest rate play such as government bonds.