Bonds lose lustre as rates rise

With Federal Reserve Chair Janet Yellen signalling that US official rates could soon rise, now's the time to review the merits of bond and other fixed interest fund investments.

With this category of investments, chosen in many cases by risk-averse investors, rising interest rates can even result in negative returns.

For the past eight years, with official and longer term interest rates continuing to fall because of widespread quantitative easing policies, bond and fixed interest returns have been boosted by mark- to-market upward revaluations of the portfolios.

The longer the period to maturity and the larger the interest rate falls, the greater the returns from capital appreciation. However, if long-term interest rates start to rise, as they have been in recent weeks, the opposite outcome occurs, with market values of longer-dated securities falling.

This is why even after receiving annual interest returns, bond and fixed interest funds can generate negative returns as their portfolios are revalued downwards.

In contrast, when interest rates rise, cash and short term fixed interest investors receive higher annual yields not reduced by falls in the capital value of the asset owned.

Bond funds can and regularly attempt to protect investors through trading and derivative activities from the adverse impact of rate rises. However, these transactions cannot fully neutralise the negative impact of higher interest rates on the market value of longer term bond and fixed interest securities.

Individual investors including self-managed super funds always have the option of purchasing longer term fixed interest investments including bonds and term deposits directly. In this situation, provided they are prepared to hold the investment to maturity, they can avoid any capital loss.

Even then, buying longer term fixed interest investments to hold to maturity is more attractive when yields are high. However, because accounting rules force bond funds to value their holdings at current market values in calculating annual returns, annual reported returns will fluctuate as rates change.

Moreover, there is no guarantee that the original capital invested will be returned. The recent rise in longer term bond yields has been generated by traders keen to lock in profits before expected interest rate rises.

Such trading and actual interest increases when they occur have dramatically increased the risks involved in owning longer term fixed interest investments.

For individual investors, even though returns from cash and short term fixed interest investments are still low, there's always the benefit of knowing that the capital invested is secure. Thus, with the prospect of interest rate rises ahead, now is not a good time to seek higher yields by investing in longer term fixed interest investments.

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Daryl Dixon

Executive Chairman

Daryl Dixon is one of Australia’s foremost investment experts and a well known writer and consultant. He has provided trusted advice to thousands of personal clients over more than 25 years and is an acknowledged expert in the areas of tax, superannuation (including public sector superannuation), social security and investments.

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