It’s easy to think that fixed income investing is as constant as the stars. But it doesn’t always work that way. While typically viewed as defensive assets, fixed income investing is not without risks. Last year provided a painful reminder of this to many investors as some bond indices suffered their worst losses on record.
Two key risks when investing in bonds contributed to this outcome:
- interest rate risk; and
- credit risk.
A large proportion of bonds are ‘fixed rate’, that is they pay a fixed coupon (or rate of interest) for the life of the bond with the payment schedule set at the time that the bond is issued. Fixed rate government bonds can be particularly long dated – 10, 20 or even more years until maturity.
Inflation is however a ‘fixed rate’ bond’s enemy.
Inflation erodes the purchasing power of its future cash flows. If inflation is increasing, the real return (i.e. adjusted for inflation) on a bond issued when inflation was lower is reduced. As a result, new bonds are likely to be issued with higher coupons. This makes similar bonds issued previously less attractive.
For this reason, bond prices in the secondary market can trade higher or lower than the face value (i.e. the initial capital value at issue, usually $100) depending on the economic environment and changes in interest rates.
If interest rates are increasing, the market value of bonds already issued usually declines and vice-versa. The longer the bond’s maturity, the greater the impact a change in interest rates typically has on its price.
In addition, while government bonds issued by the likes of Australia and the US are typically considered default risk free, bonds issued by corporates are deemed to carry the risk of default. This essentially means that the issuer may be unable to make the coupon payments when due and/or repay the principal (i.e. face value) on maturity. They are not capital guaranteed.
When taking on this risk when providing money to a corporate, investors demand a higher return. Credit spreads are an indication of the additional interest or return demanded for providing money to a corporate rather than the government.
The risk of default is also impacted by the economic environment. When the outlook is good, credit spreads tighten (i.e., investors are willing to accept lower additional interest above government bonds with similar maturities), and vice-versa when the economic outlook deteriorates. Intuitively this makes sense, because the risk of a corporate default is deemed to be greater during tough economic periods like recessions.
Last year was unfortunately a near perfect storm for fixed income investors. Not only did the unexpected spike in inflation globally prompt the greatest monetary policy tightening in post-World War II history and a massive spike in bond yields, but tighter monetary conditions, combined with the removal of fiscal support, led to a deteriorating economic outlook and wider credit spreads too.
Put simply, investors were hit by dramatically higher risk-free rates and wider credit spreads.
The good news is that with inflation slowing and improved yields following market repricing, high quality fixed income is looking better value than it has in several years. We may be finally emerging from a bond black hole and seeing a brighter future.
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