Mark Fowler: Caution over long-term, fixed-rate bonds

I've been suggesting mortgage borrowers to fix for no more than two years - and would argue in today's climate, this rule also applies for investors. Photo / 123RF

Opinion

COMMENT: For holders of fixed-rate bonds (bonds that offer a fixed interest payment over their lifetime) news of rising bond yields, or interest rates, will not be particularly welcome.

In fact, in light of all the discussions currently taking place around the potential for higher interest rates, one might expect investors to be a little reluctant to invest in corporate bonds with longer-term maturities.

Recent trends, however, seem to indicate otherwise.

This year's second quarter has seen a spate of retail bond issuances with varying maturities of between five and seven years, including the likes of Meridian, Genesis, NZX and WEL Networks.

If you buy into the aforementioned outlook for interest rates, this may be somewhat counterintuitive.

The thought process behind not investing in longer-dated maturity bonds is that they mask the reality of our local market dynamics, evidenced by the substantial demand for these new issues.

Increasingly, investors are chasing greater yields than cash can provide - I've described it before as the "growing cash problem". This search for yield tends to see investors chase the highest return while failing to consider factors such as the length of the bond, or where it ranks in security over other debt obligations of the corporate issuer.

For fixed rate bond investments, the longer it takes for interest rates to rise, the smaller the impact on the spending power you are receiving from the fixed interest payments.

For example, if you invest at four per cent today, you don't want to see interest rates at five per cent quickly thereafter.

If we consider it through a lens of constructing a bond portfolio, however, while a lift in bond yields hurts the value of existing bonds held, it will result in higher returns over time as and when new bonds are purchased offering higher yields.

It would appear investors have ultimately decided that the risk of staying in cash and generating an unsatisfactory return is too great, and are therefore prepared to invest in longer-dated bonds.

Likely, they've premised this on interest rates remaining lower for longer and an acceptance of the opportunity cost that goes with being in an investment that may not be as rewarding for its full duration.

I've been suggesting mortgage borrowers to fix for no more than two years - and would argue in today's climate, this rule also applies for investors.

It pays to be mindful of having the bulk of your fixed income investments too long term as today's rates may look very different tomorrow. It has been said that tomorrow never comes, and bond managers will certainly hope that's the case.