GOLDEN OPPORTUNITY AWAITS
Michelle Perkins, April 2023
We have observed a sharp rise in interest rates over the past 18 months, as central banks have withdrawn stimulus in an attempt to tame inflation. While higher interest rates are a concern for borrowers, they provide a golden opportunity for investors to secure the most attractive fixed income yields in more than a decade. Last year was a tough one for fixed income investors, as the significant lift in interest rates caused the prices of existing bonds to fall.
However, investors should be reminded that regular income streams from existing bonds have not changed and neither have the capital repayments they will receive at maturity (assuming there are no defaults).
Lower prices simply reflect the increase in market interest rates, which means investors are demanding a higher return (or yield) for similar securities.
As new bonds are issued (or traded) at higher yields, existing bonds New Zealand 5-year swap rate has been increasing see their market prices fall. This is because investors aren’t willing to pay quite as much for them in the secondary market.
Many private investors choose to purchase newly issued bonds and enjoy regular and predictable income over time, before getting back the capital they put in at maturity.
For these investors, nothing has changed and they can largely afford to ignore the mark-to-market price movements that happen along the journey to maturity.
Will interest rates peak this year?
It’s difficult to be definitive but inflation is moderating around the world (although not as quickly as we would like) and central banks are slowing the pace of interest rate hikes.
The Reserve Bank of New Zealand (RBNZ) has increased the Official Cash Rate (OCR) from a low of 0.25% about 18 months ago to 4.75% at the end of March. This has been one of the most aggressive periods of monetary policy tightening we’ve ever seen.
The good news is that we are approaching the end of this cycle, with the OCR expected to peak at above 5% this year.
Investors should be reminded that regular income streams from existing bonds have not changed and neither have the capital repayments they will receive at maturity.
Quality bonds are offering attractive returns
For new investors, a major benefit of the sharp rise in interest rates is that yields have increased to levels not seen in more than a decade.
Longer-dated bonds have also become more attractive. Investors can now earn annual returns of around 5.6% for a period of five or six years, which we view as a golden opportunity.
We recommend investors add high-quality bonds with 2028 and 2029 maturity dates to portfolios. A strong pipeline of new offers provides an excellent opportunity to do this.
New issues galore
March was a busy month as various New Zealand bonds reached maturity. We have seen a steady stream of new bond issues announced this year too.
Retail bond offers have totalled approximately $1.3 billion so far in 2023. While most of these new offers have been for terms of five years (2028 maturity dates), we are aware of more companies looking to issue bonds with a term of six years (2029 maturity dates).
We also expect a number of New Zealand banks to issue new securities in the coming months, as they seek to comply with the higher capital requirements over time.
Laddering reduces risk
Many portfolios hold too much in cash and short-dated term deposits. This exposes investors to significant reinvestment risk if they are holding these funds for the purpose of generating income.
Should the RBNZ win its battle against inflation or the New Zealand economy enter recession, interest rates could return to lower levels.
To help reduce this risk, we recommend investors add to high-quality senior bonds at yields above 5.4% and extend maturity dates out to six years, on a laddered basis.
By reinvesting maturing term deposits into new bonds, investors can secure today’s higher returns for five to six years, rather than have too much front-loaded which adds risk at maturity.