Fixed Interest Investments

Always Interesting

Not Always So Fixed

With interest rates rising again, it is timely to focus on Interest Bearing Investments, and how to get the best results from this important part of an investment portfolio. There is a bit of science, and a great deal of art involved and this paper addresses some of the issues to be considered.

During the mid 1970's, when short and long term interest rates were extremely volatile (rising well into double digits) I had the good fortune to work as a money market dealer. I saw from close quarters how these investments work day to day and believe that with the huge expansion of debt over the last couple of years, their importance is likely to grow again.

GROWTH/DEFENSIVE

However, before proceeding, let's take a step back.

Any well constructed investment portfolio will contain a mixture of Growth investments (such as Australian and overseas shares, real estate) and defensive investments such as interest bearing. The mix will depend on a number of factors such as risk profile, goals, financial position and current market conditions.

While our focus here is on interest bearing investments, this does not mean that growth investments are less important. Just the opposite. However, growth investments have attracted great scrutiny and analysis, while interest bearing investments have attracted far less attention.

DEFENSIVE – MAYBE

There has been a tendency to lump most interest-bearing investments together as "low risk" or "defensive". However, events of the Global Financial Crisis showed the folly of this approach. Many fell by as much as shares, which are often portrayed as "high risk".

The message is clear. Look before you leap! Carefully chosen interest bearing investments should give you a steady return, with limited risk. However, careful choice is necessary, and advice is recommended.

With our research and my experience in, we are well placed to assist you make better choices.

Let's look at some of the things that make up Interest Bearing Investments, and how they differ from other forms of investment.

PASSIVE

The first point is that interest bearing investments are by nature very passive. You are a lender of money and you invest up front to earn a certain rate of interest ( fixed or variable ) and that rate is the maximum you can get.

What is less known however, is you may get less. Generally, there are two ways you can earn less.

The real value of your interest and capital may be eroded by inflation. I saw lots of this while working in money markets. Many people who invested in the late 60's and early 70's at interest rates that were attractive at the time, saw the purchasing power of their interest and capital decimated as inflation roared well into double digits. (If inflation is at 4% then the purchasing power of your money takes 18 years to halve; if inflation is 7% it halves in 10 years, if it is 10%, it halves in 7 years.)
An interest bearing investment is a loan. If the borrower goes broke, then you may lose some or all of your capital.

Obviously, the financial strength of the borrower is critical. Governments are generally regarded as being the strongest, with (in Australia anyhow) banks not being far behind them, followed by blue chip companies. However, research is necessary.

This passive nature of interest bearing investments contrasts with an investment in shares. A share represents part ownership in a range of businesses. The businesses can be reorganised, and rejuvenated by management to adjust to changing circumstances, fix problems or exploit opportunities.

The return from shares comes in the form of capital growth and dividends, which in turn are a function of profits.

It is management's job to see that profits are maintained and hopefully grown over time, or if the company gets into trouble, management must undertake activities to turn it around (in a worst case scenario, if all else fails, it will go broke).

This is where the contrast with interest bearing investments gets interesting. So long as the borrower remains solvent, profitability is irrelevant to the level of interest paid. The borrower has a contractual obligation to pay (either a fixed or variable rate).

Generally speaking, lenders do not gain anything from rising profits, or suffer from falling profits, unless the falls are extreme and prolonged. But, if profits fall far enough, and the Company goes broke they may lose capital and interest (But usually will get paid ahead of shareholders.)

RETURN & RISK

As with any investment, there is a strong relationship between risk and return. The safer the investments, the lower the interest rate (return).

Over recent years there have been many widely publicised examples of people losing sight of this important principle, and suffering big losses as the businesses they lent to, went broke.

Watching from the sidelines, it seems that there is a process whereby small increases in rates offered can result in many more people willing to lend money. This is referred to by some commentators as an "asymmetry" – very risky borrowers only have to offer slightly higher interest rates to attract money (i.e. the extra interest does not compensate for the extra risk.)

The moral is very obvious:

Be very wary of people wanting to borrow money, and willing to pay interest at well over the odds.

DIVERSIFY

The principle of diversification is as important as ever. Discard it at your peril (But diversification must be logical, considered and structured. It is a lot more than just scattering money around. A whole industry has grown up around it.)

FIXED OR VARIABLE

Apart from call accounts such as cash management, most interest bearing investments have you committing your investment for a set period, in order to receive a definite rate of interest. (They may let you redeem them early, by paying a penalty.)

One of the most common of Fixed Interest investments is the good old "term deposit", as offered by banks, and other deposit taking institutions.

Some typical periods are:

3 months

6 months

9 months

1 year

2 year

However, the periods may vary depending on the funding needs of banks, and periods up to several years are not uncommon.

The interest rates also change, with changing market conditions (but once you invest, you are locked in for that term). When the term is up, and you want to re-invest, rates for reinvestment may have gone up or down.

BONDS

A favourite of fixed interest investors is Bonds, offered by Government and major companies.

Most investors in bonds are institutions, and it is a very active market. Daily trading takes place outside the glare of publicity which accompanies stock market trading, but the total volume is several times the volume of share trading.

When Governments or companies borrow money this way, it is usually for the longer term (2 years to 10 years are common, (but it can be longer.) In places such as U.S.A, terms may be up to 30 years)

RISKS

While there is apparent security in fixed interest investments, there are also some risks to take into account.

The borrowers may go broke (see above)
Inflation may erode the value of your capital, and interest (see above).
Interest rates may rise. Paradoxically, rising interest rates will depress returns on fixed interest investments (and may make them negative), while falling rates will be positive for returns.

It works like this:

If you bought (say) a 10 year Government Bond, paying 6%, and wanted to sell it the next day, and 10 year rates were still 6% you would get back what you paid for it (plus 1 days interest).

If, however, overnight, interest rates had risen to 7% (and stayed there), nobody is going to pay you 100 cents in the dollar for an investment, paying 6%, when they can get 7%, with identical security elsewhere.

Consequently the market value for 6% loans will drop, to bring their total payout over the full lifetime to 7% p.a. (which will be made up of regular interest payments plus capital gain on maturity). The capital gains are the difference between the price paid for the bonds and the full face value (100 cents in the dollar) on maturity.

A complex mathematical formula is used to work out the exact values, but some general principles are:

The longer the term of the investment, the greater will be the drop in value, for a given rise in rates.
The greater the rise in rates, the greater will be the drop in value.
Thus the greatest drop in value will be felt by long term bonds when rates rise the most.
Conversely, when rates fall, the capital value of the bonds rises. This leads to the "great paradox" of investing in fixed interest investments, namely -

"They perform best in times of falling interest rates, and worst in time of rising interest rates."

VARIABLE RATES

As the name suggest, variable rate investments offer interest rates that change with changing market conditions.

Typically, they pay a rate of interest that is a certain amount over a given benchmark (such as the bank bill rate). Then, as the benchmark rate rises (or falls) the interest paid by the borrower rises (or falls).

Variable rate investments thus overcome one of the main problems associated with fixed rate investments – poor performance in time of rising rates.

However, the borrowers are mainly companies, of varying credit-worthiness, and hence it is necessary to do your homework.

CURRENT

So, after all this, what approach should be considered when investing in this part of portfolio?

The best place to begin is with the outlook for interest rates.

To start with, the situation is a bit different, whether you are talking about short term or long term rates. No doubt, short term rates have been rising – as the press have reported on many occasions.

Equally many commentators feel it's likely that the Reserve Bank will keep raising rates as the economy recovers. Short term rates are the ones most affected by actions of the authorities, such as the Reserve Bank.

Long term rates are not directly affected by Reserve Bank actions, and are set by market forces. Until recently, the difference between short term and long term rates has been very high by historical standards. (This is sometimes referred to as the "yield gap") Thus, long term rates may rise, over coming months, but not as quickly as short term ones. They are unlikely to fall.

Thus, some current thoughts apply:

As far as fixed interest goes, prepare to stick to term deposits, with a maturity no greater than 1 year (and probably shorter – but it depends on the rates.)

With this approach, you will not be locked in to inferior returns if rates keep rising, but will be able to renew at the higher return at maturity, within a reasonable period.

Further down the track, when interest rates stop rising – extend the period of the investment to lock in the returns.

2. Include variable rate investments – but stick with quality.

3. Watch longer term fixed interest investments closely.

CAN WE HELP

For further assistance or a review of your current portfolio and personal circumstances, please get in touch.

The author of the above is John Cameron – B.Ec; B.Comm; MBA. John is a Director of Black Swan Event Financial Planning and an Authorised Representative of Paragem Pty Ltd AFSL297276.

GENERAL ADVICE WARNING

Please note that any recommendations do not take full account of all of your circumstances and you should decide whether or not they are appropriate for you before deciding to act.

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