Mark Lister, 18 November 2021

We all know that while shares rise over the long-term, over shorter periods it’s very common for them to fall in value.

However, investors are much less used to seeing their fixed income or bond portfolios decline. In fact, I suspect a few are unaware that this can even happen.

Bonds can go down too, and that’s exactly what’s happened this year.

As at the end of October, the NZX Government bond index had fallen 7.6 per cent in 2021. That puts it on pace for the first annual decline since 2013, and before that 1994.

The NZX corporate bond index has held up better, although it has still slipped 5.1 per cent this year.

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This isn’t because companies have defaulted on their debt obligations, nor does it mean you won’t get your capital back for that corporate bond you bought last year.

It’s because many fixed income securities (whether they’re issued by governments or corporates) trade on the open market. Just like shares, prices are changing all the time based on what buyers and sellers are willing to pay.

Among other things, bond prices have an inverse relationship with interest rates. When interest rates fall the price of existing bonds will rise, and when interest rates rise bond prices will fall.

Let’s say you bought $100 worth of five-year corporate bonds six months ago, paying an annual coupon (which is basically the interest payment) that equated to a yield of two per cent.

That yield would’ve been a function of where interest rates were at the time, which in turn would’ve been based on growth and inflation expectations, as well as central bank policy and market conditions.

Since then, let’s say growth and inflation have been stronger than expected, and the central bank has raised its cash rate. Investors are now demanding a higher interest rate for bonds with a similar risk profile to the ones you bought.

Your bonds are still going to pay you the agreed level of interest for another four and a half years, and you’ll still get your $100 back in full at the end of that.

However, financial markets no longer value this income stream quite as highly. Interest rates have risen and compared with the new bonds that are being issued, the rate you accepted back then no longer looks quite as attractive.

If you wanted to sell your parcel of bonds to someone else today, you’d have to accept slightly less than the $100 you paid for them.

This is exactly what’s happened over the past 12 months. The five-year interest rate in the wholesale market is around 2.7 per cent, up from 0.5 at the beginning of 2021 and well above where it was at the worst of the pandemic.

It’s now at the highest in three and a half years, which means many bonds of a recent vintage have seen their market prices fall. As a result, many conservative KiwiSaver funds have experienced negative returns for the first time in a while.

While these price moves are genuine, investors will only crystallise these losses if they sell.

Private investors rarely sell on market. They usually invest in bonds, collect the income stream along the way, and await the return of their money at maturity.

If this is the case, nothing has changed. They'll get back exactly what they put in, and they can afford to ignore the moves in prices along the way.

One of the most important things for an investor to do in a changing interest rate environment is to ‘ladder’ their fixed income portfolio. This simple (but highly effective) concept means ensuring a portfolio contains securities with a range of different maturity dates.

If rates are falling, investors will benefit from having locked in some income. When rates are rising, as one security on the ladder matures this capital can be reinvested in a new security at the prevailing (and higher) interest rate.

An unappreciated silver lining of the last 12 months is that reinvestment opportunities have improved dramatically for fixed income investors.