In the previous 5 years the global economy has seen record low cash rates with the United States at 0.25%, Britain at 0.50% and Australia at 2.50%. This week LJ Financial Group reviews how this affects the bond market and how bonds still play an important part of any truly diversified portfolio.
What is a bond?
A bond is essentially a vehicle through which governments and companies can raise capital. Investors “lend” money to the entity in question and receive interest payments or “coupons” based on a fixed or floating rate until the maturity date of the bond, at which point they will also be repaid their initial capital.
How is the profitability of a Bond measured?
Generally bonds are measured via the yield to maturity measure. This measures the return or “yield” if the bond is held until its maturity and all coupons or payments are reinvested into the same bond. When discussing bond “prices”, this is in reference to investors assessing the value of a bond in the secondary market when they are sold before their maturity date. The cash rate plays a large role in determining the resale value of a bond. For example, you buy a five year bond with a fixed interest rate return of 2.5% per annum. If market interest rates increase to 5% for example, then the income from your bond would only be half as valuable as it once was, reducing the value of the bond. The opposite is true for a market interest rate cut, which is why bonds have been particularly attractive during this period of increased rate reductions. This is the general analysis that is performed on any bond to predict its value or profitability of the investment.
What is happening in the Bond Market?
Like any investment vehicle a bond involves some risk, however they are traditionally viewed as a safer investment than the equity market. The reason they have been approached recently with some trepidation is due to the fact interest rates are at record lows, meaning that in a strengthening economy where a cash rate increase is becoming more likely, the value of these bonds will decrease.
This for all intents and purposes may be a technically correct outlook on bonds, but more so than most other asset classes, investors must take a long term view on bond investments and understand that the reason for investing in this market is for the financial surety of guaranteed long term return.
Given the indications that interest rates will rise in the coming years, a bond investor should not meet these changes with apprehension as the decline in bond price means a resulting increase in nominal yields and in turn potential nominal returns.
Fixed interest investment exposure should be considered in any diversified portfolio and is an important long term investment vehicle. Given the current unprecedented low interest rates, leaving the majority of wealth in cash means that for most investors this is a depreciating asset if you take into account the current inflation rate. A prudent investment in the bond market, although in the short term may see some capital value fluctuations, will in the longer term provide a core income deriving asset to a well-diversified investment portfolio.
Duncan Brown
Private Wealth Adviser
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