Filling the void with fixed income

Term deposit rates have fallen sharply over the past several months.

After hitting 15-year highs of more than six per cent last year, they’re sitting in the mid-fours today.

They’ll keep going lower, with the Official Cash Rate (OCR) likely to be slashed by another 50 basis points this month and a couple of smaller cuts to follow.

This puts conservative savers in a difficult spot, especially if they’re uncomfortable moving up the risk curve into shares or property.

Enter fixed income.

Commonly referred to as bonds or debt securities, fixed income is the cornerstone of many an investment portfolio.

It offers a predictable income stream, and is typically much less volatile than higher growth asset classes.

Fixed income refers to investments that provide regular interest payments (or coupons) and return your principal at maturity.

When you invest in fixed income or purchase a bond, you are essentially lending money to an entity – a government, corporation, or local council – in exchange for these payments.

Bonds share many characteristics with term deposits, although they can be traded on the market just like shares, which means the prices can move around.

Fixed income prices move inversely to yields, or interest rates.

When interest rates rise, the value of existing bonds falls because they look less appealing than new bonds which are being offer at higher yields.

That happened in 2021 and 2022, as the OCR was rising from the COVID-19 lows.

Importantly, bond investors still got their capital back upon maturity, it’s just that prices fell in the meantime to reflect the opportunity cost of higher rates on offer.

Conversely, if interest rates are falling existing bonds (that were issued when interest rates were higher) will rise in value.

Many fixed income investors ladder their investments by owning a range of bonds to spread out their interest rate exposure over different maturity timeframes.

Fixed income is generally lower risk than shares or property, while offering limited growth and more modest long-term returns.

However, it’s not risk-free.

In addition to the impact of changing interest rates, investors need to consider credit risk, which is the likelihood that the issuer will default on its payments.

A government or council is a relatively safe bet, as these entities can levy taxes or rates to pay their interest bill, but a company can run into trouble if it encounters difficult times.

That’s why corporate bonds typically offer higher yields than government bonds, as compensation for that higher credit risk.

A fixed income investor needs to think carefully about the issuer and its credit rating, because they’re lending money to that entity.

Liquidity is another factor to consider, as some bonds can be difficult to sell, especially in times of volatility or market stress.

Bonds from smaller companies don’t always have a robust secondary market, compared with highly liquid instruments like New Zealand government bonds.

The structure of a fixed income security can also change the risk profile.

Subordinated offerings and hybrid securities can require a closer inspection. These can offer higher and more appealing yields, but they come with more risk.

Subordinated means this debt ranks below other instruments in terms of its repayment priority.

If the issuer hits financial strife, subordinated debt holders would only be paid after the more senior debt holders had been fully compensated.

Hybrid securities pay interest like a bond, but they can also have equity-like traits.

Some convert to shares under certain circumstances, while others have clauses allowing payments to be suspended during times of financial stress.

These securities usually offer higher returns, and they can be a useful way to boost yield across a portfolio.

However, they come with strings attached and this makes them more complex.

Subordinated and hybrid securities are also often less liquid than government or corporate bonds.

That means selling them could be difficult, or prices could fall to reflect the wider spread between buyers and seller expectations.

Fixed income can provide investors with a stable, reliable income stream for a modest level of risk.

If you’re staring down the barrel of sliding term deposit income, it might be a great solution that’s worth a look.

For most private investors, a mix of New Zealand government or local authority bonds, combined with investment-grade corporate bonds is the optimum approach.

Subordinated and hybrid securities can be a useful complement, but make sure you understand the nature of these and keep your weightings in check.

For smaller investors, diversified fixed income or bond funds can be a great option, immediately mitigating the risks of interest rate changes, creditworthiness and liquidity, while offering instant diversification.

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