31 August 2017

The bond conundrum: how risky is fixed income?

‘Fixed income’ (also known as bonds) is arguably one of the most misunderstood terms in the investment dictionary.

Indeed, the iron-clad guarantee implied in the title - also known as ‘fixed interest’ - has undoubtedly lulled more than a few investors into a false sense of security.

The fact that fixed income investors principally buy ‘bonds’, a word that, again, suggests an unbreakable promise, probably doesn’t help matters.

As the many thousands of New Zealand investors caught unawares by the finance company collapse starting in 2007 discovered, fixed interest products can at times provide neither income nor the often-assumed capital protection.

But perhaps the most confusing aspect for many bond investors is that the value of their supposed ‘fixed’ investment can fluctuate over time along with prevailing interest rates: a process that is most disconcerting, of course, when the value goes down.

Given that many retirees rely on the apparent safety and stability of bond investments to deliver them income above bank term deposit rates, those valuation surprises can come as a nasty shock.

Risk comes from not understanding what you are doing

Risk comes from not understanding what you are doing

However, clued-up investors are well-placed to react appropriately to any change in their fixed income values. Somewhat worryingly though, a recent survey by the Financial Markets Authority (FMA) – which regulates the investment sector in New Zealand – found a reasonable proportion of investors did not fully understand the risks involved with bonds.

Among other findings, the FMA survey discovered:

  • Only 1% of people who invested in bonds knew its interest rate, and just 64% knew the maturity date
  • two-thirds (67%) said they were certain the company or government issuer would pay their money back, but only 44% knew the credit rating of the bond
  • just 52% of all respondents knew that bonds were investing in a form of debt (even among people who had bought bonds this was only 64%)
  • only 38% knew that bonds are not guaranteed
  • just 39% knew that bonds don’t keep their original value if you sell them before the maturity date.

Interestingly, over 25 per cent of all respondents said bonds were always low risk and/or came with a money-back guarantee - a figure that rose even higher (close to 33 per cent) for those who had bought bonds.

Paul Gregory, financial capability director at the FMA, said bond investors should better acquaint themselves with the risks, especially if interest rates rise (as this could lower the value of current bond investments).

“Investing in bonds is often associated with greater certainty and lower risk, but that’s not always the case,” Gregory said.

“It is important investors are not unnecessarily surprised if that happens to their bonds in those conditions. Don’t panic. Don’t sell or switch out just because you have some negative returns. Think about whether you’re still on track for your longer-term goals before making any decisions.”

The New Zealand Stock Exchange in Wellington

The New Zealand Stock Exchange in Wellington

While the FMA survey highlights the need for retail bond investors to do more homework, it didn’t touch on the most common method professional fixed income investors adopt to protect their portfolios: diversification.

In fact, diversification – or holding a wide range of underlying securities – is often seen as more critical in fixed income portfolios than for share investors.

Just consider a notional portfolio of four shares – valued equally. If one of those share values collapsed to zero the portfolio could still recover all losses (and more) if the remaining three perform well.

However, if one holding defaulted in a comparable portfolio of four equally-priced bonds, 25 per cent of your capital has disappeared with no hope of recovery.

Lifetime, for instance, takes this diversification message very seriously. About 45 per cent of the fund is invested in fixed income markets via global fund management giant, Vanguard, and NZ firm, Harbour Asset Management.

In one of the two Vanguard fixed income funds used by Lifetime, there are more than 1,400 underlying bonds, which understandably lowers the risks for investors.

Diversification helps you spread your investment risk

Diversification helps you spread your investment risk

Article written by David Chaplin, Lifetime Retirement Income.

What could your retirement income be?