Investment Insight | On the road higher
As inflation and interest rates increase, bond portfolios have experienced volatility. Although market uncertainty can be challenging, it does present opportunities for investors.
In this Investment Insight we are going to step back and discuss what determines the return investors receive from a bond.
A bond is the same as any other asset in that its return is comprised of two components – the income it generates and the capital value of that asset.
The first of these is simple to determine – the income you receive from a bond is the (typically fixed) coupon that a bond pays quarterly or semi-annually.
It is the capital value of a bond that may lead to confusion. Its value can move in a way that is not initially obvious. A good way to describe the change in capital value is to use property as a comparison, as this is an asset class most people are familiar with.
As well as being something we can own, a property can generate income through rent. When the rent is agreed, it is usually fixed for a set period of time. The property will have a market value: in Auckland, for example, it might be a house worth $1 million. The yield on the property is the market value divided by the annual rent you receive for it. So, if you receive $30,000 per annum, the yield on the property is 3%.
If the market value goes up to $1.1 million but the rent stays the same, the yield falls to 2.72%. Conversely, if the property values fall, say to $850,000, the yield goes up to 3.53%
This shows that if an asset has a fixed income, its yield will be inversely related to its price. When yields rise, this means prices are falling and when yields fall this means prices are rising.
This is exactly what happens with bonds. The coupon income you receive is fixed, so any change in the market value of the bond will lead to an inverse change in the yield.
So what causes changes in the market price of a bond?
Just like the property market, bonds are bought and sold every day, either in the secondary market or via new issues. The price or yield at which they are sold depends on a number of factors. These include:
The general level of interest rates: Interest rates in the economy change over time due to the level of economic activity, optimism or pessimism about the future, and through the actions of central banks setting short-term interest rates - in New Zealand’s case, the Official Cash Rate (OCR).
The market yield of a bond will change as the general level of interest rates change. If interest rates are generally rising, then the market yield of an individual bond will also increase. Given the inverse relationship discussed above, this means the price of that bond will fall. An example of this is the Kiwibank November 2030 bond. This bond was issued at $100 in November 2020 with a coupon rate of 2.36%. The current market yield of this bond is 3.35% (approximately 1% higher than when it was issued) and the corresponding market price is $96.00. This decline in price is not due to concern around the financial status of Kiwibank. It purely reflects changes in the market level.
Issuer risk: The more risky an investment, the more investors expect to receive for taking that risk. For bonds, this is known as the credit spread, and is represented by an additional amount of interest paid on an individual bond above the market interest rates.
The coupon rate that is set when a bond is first issued will incorporate this credit spread. Going forward the secondary market price of this bond will also incorporate a credit spread which can change based upon demand and supply.
This credit spread can change for two reasons. The first is due to market-wide views around credit risk. When investors are optimistic about the future, they are willing to accept a smaller credit spread across their portfolio. This lowers the market yield of each bond which increases its price. Conversely, during times of market stress and uncertainty, investors become more cautious around risk and they demand a higher spread before they are willing to invest. This drives the yield of a bond higher which – you got it! – leads to a lower price.
The second reason for a changing credit spread is due to developments specific to the individual issuer (normally a company but also governments, councils, etc). For example, a company may choose to purchase another company using a large amount of debt. This makes it a riskier investment so the credit spread will increase. Similarly, a company may have a hit product that significantly boosts its earnings and allows it to repay outstanding debt. This will lead to a narrower credit spread which will boost the price of their bonds.
Term: The last factor to influence the price of a bond is its maturity date. Bonds are typically issued for periods of 3, 5 or 7 years. A longer investment term means that any changes in the market prices are compounded over a longer time frame.
A comparison would be the decision to fix the interest rate on your mortgage. If you choose to fix for a short period, such as one year, any changes between the rate you agreed, and the market interest rates will only be for one year. However, if you fix for a longer term of, say, five years, then any differences between your agreed rate and the market rate will apply for a number of years.
For bonds, the simple rule of thumb is to multiply the term of the bond by the market change in the yield. If you hold a bond that matures in 1 year and market interest rates increase by 1%, then the price of your bond will decrease by (-1% x 1 year) = -1%. However, if you hold a bond that matures in 10 years then the price of your bond will decrease by (-1% x 10 years) = -10%. This shows that the volatility of bond prices is a function of the term to maturity.
This relationship is a key reason that returns on bond focused portfolios have been challenged in 2021. Many bond funds in New Zealand will maintain an average portfolio maturity of around 5 years. So as interest rates have generally increased over the year, the inverse relationship between yield and price has led to price declines.
As interest rates move back up to more normal levels, bonds will provide higher levels of income to investors than has been experienced over recent years and can act as a stabilising component in well-constructed and diversified portfolios.
At NZ Funds we look to actively manage the risk of interest rate increases to mitigate their impact on portfolios. As active managers, we won’t always get it right, or we can be right yet too early. But we firmly believe that active management is the best way for clients to achieve their long term goals and we’re working hard to navigate the changing environment and capture investment opportunities.
In this Investment Insight we are going to step back and discuss what determines the return investors receive from a bond.
A bond is the same as any other asset in that its return is comprised of two components – the income it generates and the capital value of that asset.
The first of these is simple to determine – the income you receive from a bond is the (typically fixed) coupon that a bond pays quarterly or semi-annually.
It is the capital value of a bond that may lead to confusion. Its value can move in a way that is not initially obvious. A good way to describe the change in capital value is to use property as a comparison, as this is an asset class most people are familiar with.
As well as being something we can own, a property can generate income through rent. When the rent is agreed, it is usually fixed for a set period of time. The property will have a market value: in Auckland, for example, it might be a house worth $1 million. The yield on the property is the market value divided by the annual rent you receive for it. So, if you receive $30,000 per annum, the yield on the property is 3%.
If the market value goes up to $1.1 million but the rent stays the same, the yield falls to 2.72%. Conversely, if the property values fall, say to $850,000, the yield goes up to 3.53%
This shows that if an asset has a fixed income, its yield will be inversely related to its price. When yields rise, this means prices are falling and when yields fall this means prices are rising.
This is exactly what happens with bonds. The coupon income you receive is fixed, so any change in the market value of the bond will lead to an inverse change in the yield.
So what causes changes in the market price of a bond?
Just like the property market, bonds are bought and sold every day, either in the secondary market or via new issues. The price or yield at which they are sold depends on a number of factors. These include:
The general level of interest rates: Interest rates in the economy change over time due to the level of economic activity, optimism or pessimism about the future, and through the actions of central banks setting short-term interest rates - in New Zealand’s case, the Official Cash Rate (OCR).
The market yield of a bond will change as the general level of interest rates change. If interest rates are generally rising, then the market yield of an individual bond will also increase. Given the inverse relationship discussed above, this means the price of that bond will fall. An example of this is the Kiwibank November 2030 bond. This bond was issued at $100 in November 2020 with a coupon rate of 2.36%. The current market yield of this bond is 3.35% (approximately 1% higher than when it was issued) and the corresponding market price is $96.00. This decline in price is not due to concern around the financial status of Kiwibank. It purely reflects changes in the market level.
Issuer risk: The more risky an investment, the more investors expect to receive for taking that risk. For bonds, this is known as the credit spread, and is represented by an additional amount of interest paid on an individual bond above the market interest rates.
The coupon rate that is set when a bond is first issued will incorporate this credit spread. Going forward the secondary market price of this bond will also incorporate a credit spread which can change based upon demand and supply.
This credit spread can change for two reasons. The first is due to market-wide views around credit risk. When investors are optimistic about the future, they are willing to accept a smaller credit spread across their portfolio. This lowers the market yield of each bond which increases its price. Conversely, during times of market stress and uncertainty, investors become more cautious around risk and they demand a higher spread before they are willing to invest. This drives the yield of a bond higher which – you got it! – leads to a lower price.
The second reason for a changing credit spread is due to developments specific to the individual issuer (normally a company but also governments, councils, etc). For example, a company may choose to purchase another company using a large amount of debt. This makes it a riskier investment so the credit spread will increase. Similarly, a company may have a hit product that significantly boosts its earnings and allows it to repay outstanding debt. This will lead to a narrower credit spread which will boost the price of their bonds.
Term: The last factor to influence the price of a bond is its maturity date. Bonds are typically issued for periods of 3, 5 or 7 years. A longer investment term means that any changes in the market prices are compounded over a longer time frame.
A comparison would be the decision to fix the interest rate on your mortgage. If you choose to fix for a short period, such as one year, any changes between the rate you agreed, and the market interest rates will only be for one year. However, if you fix for a longer term of, say, five years, then any differences between your agreed rate and the market rate will apply for a number of years.
For bonds, the simple rule of thumb is to multiply the term of the bond by the market change in the yield. If you hold a bond that matures in 1 year and market interest rates increase by 1%, then the price of your bond will decrease by (-1% x 1 year) = -1%. However, if you hold a bond that matures in 10 years then the price of your bond will decrease by (-1% x 10 years) = -10%. This shows that the volatility of bond prices is a function of the term to maturity.
This relationship is a key reason that returns on bond focused portfolios have been challenged in 2021. Many bond funds in New Zealand will maintain an average portfolio maturity of around 5 years. So as interest rates have generally increased over the year, the inverse relationship between yield and price has led to price declines.
As interest rates move back up to more normal levels, bonds will provide higher levels of income to investors than has been experienced over recent years and can act as a stabilising component in well-constructed and diversified portfolios.
At NZ Funds we look to actively manage the risk of interest rate increases to mitigate their impact on portfolios. As active managers, we won’t always get it right, or we can be right yet too early. But we firmly believe that active management is the best way for clients to achieve their long term goals and we’re working hard to navigate the changing environment and capture investment opportunities.
Source: Bloomberg.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
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Mark Brooks is Portfolio Manager for New Zealand Funds Management Limited (NZ Funds) and a member of the NZ Funds KiwiSaver Scheme. Mark's comments are of a general nature, and he is not responsible for any loss that any reader may suffer from following it.
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