Wednesday 01 June 2011 by FIIG Securities FIIG Securities Legacy

The relationship between fixed rate bond prices and yields

Please note that the figures mentioned in this article are no longer available.

Fixed rate bonds provide direct exposure to interest rates. In a market where interest rates are declining, which usually occurs where there is low or negative growth and the RBA is easing rates (cutting the cash rate) to try and stimulate the economy, fixed rate bond prices rise.

So at the very time the share market is likely to underperform, in that period of low or negative growth, owning fixed rate bonds would support the overall performance of your portfolio. Losses in shares or property could be offset by higher fixed rate bond prices. In extreme stress, these bonds could be sold at a profit.

Let me explain fixed rate bonds in a bit more detail.

Fixed rate bonds are issued with a set coupon for the life of the bond. For example, last week QBE issued a US$1bn fixed rate subordinated bond which pays a fixed 7.25% coupon for ten years until May 2021, when the coupon will be reset (the total life of the bond is 30 years).

The coupon on the US$ QBEs will not change for the next ten years. This provides the company with funding certainty as well as providing certainty for the investors, who will derive a known income for the ten years. During the next ten years, the market perception of interest rates, along with official US rates, set by the Fed will change. No matter what happens the company and those investors that bought the bonds in the primary market will maintain that 7.25% cost/ income.

However, over those ten years, some investors will want to sell the bonds. The only way those bonds can reflect changes in perceptions and actual interest rates, is by changing their price. It is possible for bonds to trade at a premium, that is, more than their $100 face value.

When interest rates fall, fixed rate bond prices rise, and the reverse is also true, when interest rates rise, fixed rate bond prices fall. Put simply, think of a see-saw in perfect balance. If you buy a bond with a face value of $100 with 10 years to maturity which pays a 5% coupon (which is also the interest rate the market expects), if interest rates decline to 4%, then the bond price must increase to $108.176 to maintain the initial 5% return, so that the see-saw remains balanced. The reverse is also true. A rise in rates to 6% means that for the bond to have the same initial return of 5%, the price must reduce proportionally to $92.561 (see Figures 1, 2 and 3).

Portfolio Construction

When constructing a portfolio, it’s important to consider the “big picture” risks and how you can best insulate your capital. Many investors seek the high returns offered by higher risk asset classes such as shares and property, but how do they protect their portfolios? Fixed rate bonds offer that protection. While it is true that in a rising rate environment fixed rate bond prices will decline, it’ s worth assessing longer term interest rate expectations as often increases are already built into the market.

FIIG’s current preference is for floating rate notes over fixed rate bonds, in part due to our expectations of interest rate rises over the next 12 months and in part due to the pricing of 10 year bond futures. See the article From The Trading Desk.

However, investors should still consider longer dated fixed rate bonds to offer some portfolio protection and diversification.