Most people understand shares but there are many investors that have exposure to fixed interest markets but have little understanding of the nature of this asset class and the associated risks.
The assets class known as “Fixed Interest” usually regarded as a defensive asset class can sometimes be anything but “fixed” and anything but “defensive”. Many investors hold these assets either directly to compliment a direct share portfolio or as part of a diversified “Balanced” or “Moderate” holding in their super fund.
The fixed interest sector includes a wide range of different types of investments with differing risk characteristics. It includes Government and Corporate Bonds, Capital Notes, Debentures, Listed Income Securities and Term Deposits. It’s a complex area and each of these investment types has different characteristics, some paying a fixed coupon rate some paying a floating rate return. Some converting to shares down the track. Some with guaranteed repayment of capital, others not.
A fixed interest security is only as good as the issuing institution. With interest rates paid by banks at historical lows investors have been buying up bonds and income securities and have been moving up the risk scale chasing better yields.
The bank term deposit is fixed interest investing in its simplest form. The rate of interest is fixed, the term is fixed and return of capital is guaranteed by the bank. These investments are not traded in a market place so the capital value doesn’t fluctuate. Bonds are less complex than income securities and don’t contain share price risk but both are subject to capital fluctuations.
With most fixed interest investments there is a market and this allows for fluctuations in the capital value at any given point in time. These investments have an inverse relationship with interest rates. So when interest rates fall the capital value or sale value of the investments rise. Conversely when interest rates rise investors can experience a loss in the capital value of their holdings. This phenomenon is exacerbated by the duration of the security with longer dated securities more sensitive to interest rate movements
There are three main areas of concern for investors in this space right now. The first is that interest rates are at record lows around the globe. This gives virtually no room for further falls in rates in most countries going forward. The trend is up. Although there has been some recent talk of interest rate cuts in Australia essentially rates here are already at relative lows. Rising interest rates will impact investors in the fixed interest space.
The other key concern is the flattening of credit spreads. What this relates to is the different interest rates paid on investments of high quality relative to those of poorer quality. With interest rates at historical lows investors are hungry for yield and are willing to invest in lower quality offerings without an adequate reward in interest rates. This has led to a compression of interest rates across different risk offerings. This is happening across the globe. As the interest rate cycle turns and rates go up there is a risk that credit spreads will widen and those with poorer quality holdings will suffer larger rate increases with potential for a larger consequential fall in capital prices.
The third factor to be concerned about right now is the end of quantitative easing QE in the US. This tightening of monetary policy will eventually lead to higher interest rates which will feed into the other two issues discussed.Many people believe that bonds and listed income securities are safe. Well that depends on the quality of the issuer, the terms of the issue, if there is share price exposure in the offering, how well diversified your holdings are and a myriad of other factors. It’s a complex area and investors should think carefully about how they gain exposure to this important asset class. Andrew Condell