Understanding fixed interest securities or bonds

Media release - 6 June 2022

What’s been happening?

Over the past year or so, bond yields have risen sharply here in Australia and across the major bond markets of the world.

This has impacted the performance of our Diversified Bond and Diversified Bond – Index options and those diversified options with significant exposures to fixed income, such as our Conservative and Retirement investment options. Note, however, that the diversified nature of those options means that they are exposed to a range of assets, including both Australian and international shares and unlisted assets such as infrastructure and private equity. While share prices have declined this year, unlisted assets have generally continued to perform well even as bonds have delivered negative returns.

How do bonds work?

Fixed interest securities or bonds are issued (mostly) by governments and corporations. They generally pay a regular, fixed-interest income over the life of the bond and repay the face value of the bond at maturity. As with a term deposit, the interest payment is generally fixed in advance – the price, however, is not. Fixed interest securities are actively traded in markets across the world.

Price and yield

The yield of a bond is the return I get if I buy that bond today and hold it to maturity, but between purchase and maturity, the price or value in the market of the bond will fluctuate. The daily closing prices of the bonds we invest in feed into the daily unit prices we calculate for our investment options that invest in bonds.

Over any given period, the return I receive from investing in bonds reflects two components: the interest I accrued over that period, and any price rises or falls during that period. The price, or value of a bond in the market, depends on a range of factors but a key influence is the availability of other bonds that are paying either a higher or lower interest payment for the term of that bond.

If interest rates in general rise and there are other bonds that become available that are paying a higher interest payment, the value of my existing bond in the market goes down if I need to sell it. If the yield goes up, the price of the bond goes down. Put another way, buying a bond for a lower price improves my future return (i.e., I get a higher yield). But if I already hold that bond and its yield goes up, the capital value of the bond has fallen.

Generally speaking, the longer the term to maturity of a bond, the more volatile its price can be than would be the case for a short-term bond as there is a higher chance that interest rates can move up or down over that longer term.

Example

To illustrate the relationship between bond prices, yields and coupon payments, consider a government bond issued on 30 June 2022, with a 10-year term and a fixed coupon payment of 2%.

The principal of the bond is $100, which means that on 30 June 2032 the government must repay $100 to the bond’s owner.

The bond will also pay a fixed annual interest rate (the coupon payment) of 2% of the principal ($2 each year).

The yield is an estimate of the annual return an investor will earn IF they hold the bond to maturity and reinvest the annual interest rate payment at the same rate that the bond is trading in the secondary market. For example, if the yield on all 10-year government bonds trading in the secondary market is 2 per cent (the same as interest payments on our bond), then the price of our bond will be $100 and the yield on our bond will also be 2 per cent. The yield is therefore an estimate of the return an investor will earn through changes in the price of the bond as well as the fixed interest payment they receive.

If investors only required an annual return of $1 in addition to their $100 principal being paid back in 10 years, they would be willing to pay more than $100 to purchase our bond as it still offers a $2 annual interest payment. The price of our bond will increase until the point where it provides investors with their required yield of 1 per cent. This occurs when the price of our bond is $109.50.

Why have yields risen?

The global economy has continued to recover from the 2020 COVID-19 recession, and inflation pressures have been building. Markets have become increasingly concerned that the surge in inflation during 2021 will prove more persistent than earlier believed, prompting the world’s central banks to raise official interest rates sooner and faster than previously expected. As interest rates have risen, the drop in bond prices has resulted in negative returns for our fixed income options and for the fixed income allocations within Australian Retirement Trust’s diversified options.

The way forward

When investing in bonds, it’s important to remember that they are not riskless assets. This is why in Australian Retirement Trust’s Super Savings Product Disclosure Statements the recommended investment timeframe for the Super Savings Diversified Bond options is three years.

Fixed income returns can be negative in the short-term, but, over time, fixed securities should produce relatively stable, positive returns.

The improvement in the global and Australian economies has been a negative for bonds, but is a positive development for most of the businesses – both listed and unlisted – that Australian Retirement Trust invests in.

We have no way of knowing with any certainty how the economy and financial markets will evolve over the short term, and we do not invest money based on our own, or anyone else’s, short-term economic or market forecasts.

We build portfolios that are designed to achieve their medium to longer-term performance objectives as outlined in our investment guides.

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