A typical bond has a term of 5 to 7 years at a fixed interest rate. In most cases you can sell good quality bonds at any time, but the price will vary. The bond market (it’s huge) sets the price of all bonds and generally speaking ;
- a bond value will fall if interest rates rose since you bought the bond
- a bond value will rise if interest rates fell since you bought the bond
However if you hold to maturity you will normally be repaid in full.
Future Interest rates
With interest rates around the world at an all-time low, there is only one way they can go, and that is up. As and when the world economy recovers, Reserve Banks around the world will increase interest rates to keep inflation and growth within acceptable limits.
So when interest rates rise, the value of your bonds are going to fall. You will still get the same interest rate you started out with, but if you need the money out of your bond before maturity, you are going to lose some money. How much?
I saw some recent calculations where a 2% rise in interest rates looked like an 5% to 7% fall in bond values – this is very approximate, but it paints a picture.
This is not a big problem if you have an appropriate investment strategy. By diversifying across bonds, property, and shares, you reduce your exposure to bonds straight away.
At the same time, you can diversify your bond portfolio by investing on and offshore, and spreading across a range of different maturities. In addition it would be wise to avoid any heavy weighting to fund managers are trying to forecast interest rates, since more than 50% of the time, forecasting usually fails.
You can use a fund manager such as DFA who do not forecast, and have a well proven strategy which was designed by Professor Eugene Fama of Chicago. He won the inaugural Onassis prize for services to global finance in 2009, a highly prestigious award.
And if interest rates are rising, economies will be growing, in which case shares will usually do much better than bonds. In 2012 most share market indexes have outperformed bonds.
A bond pays interest, and was never designed to be growth investment, which must come from property and shares.
Never to be ignored, and the only free ride you get when investing, diversification is critical. Our three preferred bond funds are spread across:
80 to 90 AA to AAA global bonds
300 to 400 BBB to AAA global corporate bonds
120 BBB to AA NZ bonds
Bonds – for
Bonds - against
- Low risk, especially above A ratings
- But can fall in value if interest rates rise
- Safe haven in difficult times
- Yes, but reduced safety if excessive demand
- Can spread maturity dates by laddering
- Not enough choice in NZ
- Steady income
- About 5% pa. for quality in NZ
- Can get wide diversification offshore
- Not enough choice in NZ
- Huge efficient & deep market
- NZ bonds expensive at present
- Good bonds are always liquid
- At less than you paid if interest rates rise sharply
- Low buy & sell costs
- Unlikely to maintain pace with inflation
- Global funds can get 7% plus*
- Little capital growth
- Our preferred funds may be a better way
- Hard to manage unless you know your stuff
* our preferred global fund has consistently averaged over 7% pa. but of course future returns cannot be guaranteed
It is best to avoid putting all your money into one asset class, especially if that asset class is overbought, and bonds certainly are at present. Overall, a diversified portfolio of bonds, property, and shares is arguably lower risk than a bond only portfolio.