Brent Sheather: Time value of money needs weighing up

At the start of this year, the consensus among financial advisers, economists, stock brokers and all those others that frequently get their forecasts wrong was interest rates were going up, no question about it.

Quantitative easing, governments printing money and the higher oil price all pointed to higher inflation and with it, of course, higher interest rates. Rates were low so the smart money should keep their funds in cash and wait for higher yields further down the track.

Sorry, nice dream, but wrong. In fact, interest rates are down, down, down and may well go lower. Of course, they could also go up.

It is a funny thing but people often talk about what interest rates are doing when, in fact, different interest rates have a habit of moving in opposite directions at the same time.

That is what has happened in 2010. Interest rates have gone up and they have gone down as well. It's all about the term of the interest rate - short rates are up, long rates are down.

Short-term interest rates as measured by the official cash rate, the interest rate set by the Reserve Bank to meet the inflation target, have moved from 2.5 per cent to 3 per cent this year. But that is where rising interest rates start and finish.

Everything further out on the curve is down. Five-year government bonds have fallen from 5.5 per cent to 4.4 per cent and 10-year government bonds are down by 1 point from 6.1 per cent to 5.1 per cent. The five-year swap rate, which is the rate the banks pay to borrow from each other, is down 1.4 points from 5.6 per cent to 4.2 per cent.

It is actually not surprising rises in short-term interest rates could cause long-term rates to fall because higher short-term rates act to constrain economic growth and thus reduce the chance of inflation in the future.

Lower interest rates are bad news for people about to retire but great if you didn't buy the "consensus" back in January and instead put a bit of money into long bonds as insurance against deflation.

These lower interest rates have meant equity-like returns for bond investors - 10-year governments have returned 11.7 per cent so far in 2010, not bad going for a government guaranteed investment in just over seven months.

A popular 10-year corporate bond returned 13.4 per cent in the same period - the yield dropping from 7.2 per cent to 6 per cent.

So how do falling bond yields equal higher bond prices? A simplified example will help an understanding of why bonds act like this. Take the 2021 NZ government bonds.

When they were originally issued, they paid a 6 per cent interest rate on the value of the funds issued, which we can assume was $1000 for this example. So, looking at the cash flows, someone who bought $1000 of 2021 government bonds is going to receive $60 each year until 2021.

But $60 received in 2011 isn't the same as $60 received in 2010, because you could invest that money at the prevailing interest rate at the time; if you invested $56.60 at 6 per cent in 2010, this would be worth $60 in 2011.

So what we need to do to reflect the "time value of money" is to discount each of the cash flows by the prevailing market interest rate. In this case, we divide the $60 received by 1 plus the applicable interest rate.

This may be confusing but an example will hopefully make it clearer. For the 2021 bond, if the prevailing interest rate today is 6.4 per cent, the numbers are as follows:

The formula looks imposing but it is really quite easy to work through. In the first column, the number is just 60 divided by 1.064 which is 56.4. So if we do the calculations for the first three years using a 6.4 per cent interest rate, we get a value of the bond coupons of $56.40 + $53.10 + $50.00 = $159.50.

If interest rates increase to 7 per cent, the discounted value of the first three coupons falls to $157.50. Note we are just adding the first three coupons here to 2012 when, in reality, the 2021 bond will keep paying $60 a year until 2021. That is how and why bond prices fall when interest rates go up. Easy peasy.

It works this way because as the rate at which the interest coupon is discounted increases, the value of the coupons fall. Remember, too, the longer the maturity of the bond, the more sensitive the price is to changes in interest rate.

At the other end of the spectrum, the capital value of a short-term deposit with a bank is virtually unaffected by a change in interest rates as the deposit has a short-term maturity.

This is another good reason why retail investors should not have too much in short-term deposits, especially if they have a share portfolio, because the effect of longer dated bonds going up in price when there is bad news on the economy has a great stabilising effect on a portfolio; that is, when shares go down, long-term bonds often go up.

Bonds can confuse investors. This is a concern because the average pension fund has about 40 per cent of its money in bonds, while anecdotal evidence suggests the average retail investor has far too much money in short-term bonds - that is, bank deposits.

That means they have missed out on the great capital growth that has occurred of late from owning long-dated low-risk bonds; they've missed out on the diversification benefits; and, when they reinvest their bank deposit next year, they are likely to be confronted with much lower interest rates.

A client sent an email the other day saying he wanted to buy a bond but he didn't want to pay a premium for it. This is a strange comment for a number of reasons, but it highlights that even some sophisticated investors don't really understand how the bond market works but have a fear of paying a premium.

It is important to be clear that you pay a premium for a bond where premium is defined as a price higher than prevailed when it was originally issued, if interest rates have declined since the original issue.

Paying a premium in no way detracts from the yield of the bond or its attractiveness. A government bond might have been issued at 6 per cent originally and now be trading at a price to yield of 5.4 per cent.

If interest rates on government bonds are now 5.3 per cent, then a bond yielding 5.4 per cent is relatively attractive irrespective of whether it was originally issued at 6 per cent.

If you pay a premium for a bond, this is factored into the price of the bond and the yield calculation, so paying a premium or buying it at a discount is irrelevant.

The key question is "is the yield attractive", because the yield takes into consideration the price and whether the bond is trading at a premium or a discount.

One last thought. With 10-year government bonds yielding "just" 5.1 per cent at the moment, some people think these rates are too low and look at something else.

Be careful: Warren Buffett is on record saying he keeps all his fixed-interest money in government bonds which have the attraction they repay your capital.

For some perspective on how low our interest rates are, or are not, consider in America 10-year government bonds yield just 2.5 per cent and, if that is not bad enough, negative bank interest rates are again being discussed in some circles.

* Brent Sheather is an Auckland financial adviser and his adviser/disclosure statement is available on request and free of charge.