Interest rate rises during the second half of 2016 took the edge off returns from fixed interest investments.
For the six months to 31 December 2016, our Australian and International Fixed Interest options had negative returns of 1.6% and 1.3% respectively. While this came as a surprise to some members, the reality is that even though fixed interest investments are considered to be lower risk, this doesn’t mean risk free. The returns from fixed interest investments do fluctuate and can occasionally be negative.
Understanding fixed interest
The most common type of fixed interest investment is a bond. A bond is a loan between two parties. The lender (such as a super fund) buys the bond and the borrower (usually the government, a semi-government body or a large corporation) issues the bond as a way of raising money. The borrower makes regular interest payments (coupon payments) for the term of the bond, and at the end of the term (the maturity date), the original investment (face value) is returned.
While bonds can be held to maturity, it’s more common for financial institutions such as super funds to trade bonds in the bond market before maturity. Even if a super fund does hold the bond to maturity, the daily unit price for the investment option holding the bond will vary to reflect changes in the bond’s market value. So just like the share market sets values for share prices, the bond market sets the current market price for bonds.
What drives bond values?
Bond values are driven by interest rate expectations. So the market value of a bond depends on supply and demand in the bond market, which in turn, are driven by actual and expected interest rate movements. While a bond’s face value, regular interest payments and maturity date don’t change, any movement in interest rates, or expectations of movements in interest rates, will change the bond’s market value.
Which brings us to the fundamental relationship between bond prices and interest rates: When interest rates fall, the market value of existing bonds tends to rise. When interest rates rise, the market value of existing bonds tends to fall. In other words, the market value of bonds reflects expectations about the future direction of official interest rates.
Here's a simple example
Let's say you bought a 10-year bond with an interest rate of 5% a year. If market interest rates halved overnight to 2.5% per year, then the income from your bond would be twice as valuable because you’re getting 5%. This would increase the market value of your bond. On the other hand, if interest rates doubled to 10%, the income from your bond would be only half as valuable and the market value of your bond would fall.
So why did fixed interest drop?
The election of President Trump raised expectations of higher interest rates and this partly explains the poor performance of fixed interest markets over the second half of 2016. For much of the year, the market was expecting the US Federal Reserve to raise rates, which had fallen to record low levels following the 2008 financial crisis. The expectation of higher rates gained momentum following Trump’s win in November. Why? Because the market expects that Trump’s plans to increase spending and decrease taxes will push up inflation.
These events led to a drop in the value of US bonds. Given the size and importance of the US bond market, the subsequent US bond selloff sent bond markets around the world lower. The fall in the market value of bonds over the past few months has been greater than the interest income from bonds, producing negative returns from our fixed interest options.