In this article we provide an overview of how interest rates can impact our fixed income returns, and why returns have been challenged recently.
A challenging environment for fixed income returns
A significant factor that has recently impacted all bond markets has been the COVID pandemic and the rapid lowering of interest rates by central banks around the globe in 2020.
On a positive note, the growth and inflation outlook are improving, helped by the rollout of vaccines and economies re-opening, giving hope of a swift return to ‘normal’. This improvement has seen longer-term bond yields rise from their record lows during the pandemic.
This change has impacted the performance of our fixed income investments. Rising yields (reflecting the better economic outlook) have had a negative effect on the prices of bonds issued during the COVID pandemic at very low rates, resulting in negative returns in some options.
What are fixed income investments?
The most common type of fixed income investment is a bond. A bond is a loan between two parties - the lender and issuer (the borrower). The issuer of the bond is typically a government or semi-government body, or a large corporation. A bond is issued as a way of raising money.
When Aware Super refers to a fixed income investment in our options, Aware Super is the lender. We pay a lump sum of money to the issuer at the start of the investment in exchange for regular interest payments (or coupons), plus a repayment of the loan amount at maturity.
A bond can be invested upon a new issuance, or in the secondary market, taking over as the lender from another institution.
A fixed income return is not ‘fixed’
The price of a bond can fluctuate throughout its life. This fluctuation is in response to the current interest rate environment. Since bonds cannot change their coupons to align with current interest rates, their prices will adjust so that their yields (returns) can do so.
Understanding fixed income yields
The ‘yield’ is simply a measure of return available from a bond. It is the income returned on an investment - like the interest received from holding a security - and is usually expressed as an annual percentage rate.
Example – the relationship between bond price and yield
A simple example is a 10-year bond with a loan of $100 that pays a 5% coupon rate fixed each year ($5). The yield on the bond when issued is therefore 5%.
Now let’s look at two scenarios: #1 where market interest rates rise; and #2 where market interest rates fall. In each case, we look at how changes in market rates affect the 10-year bond’s price and yield.
|Scenario #1: Interest rates rise to 7%||Scenario #2: Interest rates fall to 3%|
You can invest at a higher interest rate in the market compared to your coupon of $5. The price of your bond will have to drop proportionately so that the return from the bond (i.e., the yield) increases to 7%.
The price of the bond will drop to about $71 so that the yield on the bond will increase to 7%, in line with prevailing interest rates.
Given you have locked in a higher coupon than is available in the market, the price of your bond will increase.
The price of the bond will increase to about $166 so that the return (i.e., yield) on the bond will decrease to 3%.
This example shows a key relationship in fixed income investing - the price of a bond is inversely related to its yield. Interest rates aren’t the only factor that impact bond returns. When lending money, the risk and expected return depend on several key variables:
- Your exposure to interest rates
- The risk associated with who you are lending to (credit risk)
- How long you are lending money for (maturity)
Fixed income isn’t ‘riskless'
Although fixed income investments are usually less volatile than many other investments such as shares, many investors incorrectly assume they are riskless.
The coupons investors receive on bonds are ‘fixed’, but a bond’s price varies over time as it’s traded in a marketplace with buyers and sellers, which gives risk to the possibility for negative returns.
Fixed income can still play an important role in a diversified portfolio
Fixed income can still play an important part in a portfolio because it provides diversification, regular income cash flows and liquidity benefits.
Super is a long-term investment, so it’s important to have a well-diversified portfolio of good quality assets to help ride out the inevitable market ups and downs. That’s where our diversified options come in - or you can choose a mix of single asset class options.Please note that past performance is not a reliable indicator of future performance and does not guarantee returns.
If you’d like more information, or if we can help, don’t hesitate to get in touch.