Interest rates and bond prices: how to overcome the ups and downs
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When rates go up, the market value of bonds goes down; but conversely, when rates fall, the value of bonds goes up. However, not all links are created the same.
NOTICE: Bonds and interest rates generally have a checkered relationship.
When rates go up, the market value of bonds goes down; but conversely, when rates fall, the value of bonds goes up. However, not all bonds are created the same, and a bond’s sensitivity to fluctuating rates – or the size of the flip-flop – will be influenced by its maturity and whether it has a fixed or variable rate.
The first good news for retail investors is that they really only have to worry about half of this equation, as only institutional or wholesale investors usually have the option of buying floating rate bonds. In the retail market, fixed rate bonds with longer maturities will be the most sensitive to interest rate hikes, but that doesn’t necessarily mean you should seek to avoid them.
Longer-dated fixed rate bonds offer a higher yield than the spot rate, so avoiding them in favor of the protection offered by short-term bonds can negatively impact your returns. In addition, price reductions are limited by the fact that the bond issuer must repay the principal when the bond matures.
One aspect of bonds that is often overlooked is that, just like stocks, they can fluctuate daily based on market forces. But unlike stocks, bonds have a predefined end point and value. This means you know what the bond will be worth at maturity.
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One of the most common ways for New Zealand investors to gain exposure to bonds and fixed income assets is through managed funds – and the influence on fund performance of fluctuations in interest rates. interest helps to justify active management.
A savvy bond fund manager will look to go for longer maturities as rates rise and lock in rates at improved levels. Therefore, if you invest in a bond fund, it means that your potential losses will be reduced and your potential gains improved.
In addition, if the unit price of the bond fund falls due to rising interest rates, it is highly likely that future periods will experience a higher level of return. This is because, as mentioned earlier, at maturity, a bond will pay the holder the face value of the bond, regardless of the price at which it was purchased, plus coupon payments. Unless the issuer defaults, which is extremely rare, you will always be paid back in full plus interest.
So what is the risk of default on a bond? At Nikko AM, we only invest in investment grade bonds, i.e. those with a credit rating of BBB or better. An example of a bond that could be subject to default would be a bond with a rating of B or less. In the United States, riskier bonds are referred to as “high yield” or “sub investment grade”. While promising a higher return, these have an increased probability of default or a probability of not paying on time.
The influence of interest rates is also a factor, albeit to a lesser extent, when considering investing in conservative funds. Most of these funds are heavily invested in bond and cash type assets, therefore, like bond funds, the unit prices of conservative funds fluctuate with the movement of interest rates.
However, these funds have additional diversification benefits of up to 30 percent into domestic and global equities and listed real estate assets. These types of assets often perform well when interest rate markets do not, especially if interest rates rise due to an improving economic environment and the outlook for growth changes. are good news, thus offsetting the negative impact on the bond component.
So while rising interest rates present challenges for bond investors, they are not without their rewards. Remember that the secret to a successful investment is time in the market, no Schedule the market.
Choosing when to change rates is incredibly difficult, even for professionals. As such, you may want to consider holding your investment in a bond fund longer, to examine monthly increases and decreases in unit prices. In doing so, you should ultimately be rewarded for your patience.
Fergus McDonald is Head of Bonds and Currencies at Nikko AM NZ, one of Asia’s largest asset managers.