Mark Lister, 20 May 2022

  • The NZX corporate bond index is down 3.6 per cent in 2022.
  • Many bonds issued or purchased during 2020 and 2021 have seen their market prices fall.
  • The future return prospects for fixed income look better than they have in years.

It’s not just share investors that have had a volatile ride in recent months. Those with conservative portfolios or KiwiSaver funds have also suffered losses.

The NZX corporate bond index is down 3.6 per cent in 2022, which means it has still held up far better than the NZX 50 share index, which has slumped 14.5 per cent this year.

However, even modest falls have been rare in recent times, so it’s still something few investors will have experienced.

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Fixed income securities trade on the open market. Just like shares, prices are changing all the time based on what buyers and sellers are willing to pay.

Bond prices have an inverse relationship with interest rates. When interest rates fall the price of existing bonds rises, and when interest rates rise bond prices fall.

Over the last 18 months, it’s been the latter that has happened. The five-year interest rate in the wholesale market increased to more than four per cent earlier this month, the highest since 2014 and well above where it was at the worst of the pandemic.

For all the bonds that were issued or purchased during 2020 and 2021, financial markets no longer value the income streams attached to these quite as highly.

Compared with the new bonds that are coming out (which are tied to today’s market interest rates), the rates that were the norm back then no longer look as attractive.

That means many bonds of this vintage have seen their market prices fall. As a result, many conservative investors (and 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.

For those awaiting the return of their money at maturity (rather than selling on market before then), little has changed.

The income stream will be the same as they signed up for and they’ll get back exactly what they put in. That means they can afford to ignore the moves in price along the way.

Still, losses are losses and nobody likes to lose money, even when it’s only on paper.

The better news is that with interest rates where they are now, the future return prospects for fixed income look better than they have in years.

The Reserve Bank still has work to do, and it’s certain to crank the Official Cash Rate (OCR) up even further on Wednesday next week.

However, interest rate markets don’t wait around for official announcements from the Reserve Bank. They react instantly to what they believe is coming.

They’ve already accounted for this week’s move, as well as a few more. In fact, there’s every chance local interest rate markets are fairly close to pushing as high as they’ll go this cycle.

In recent weeks, future pricing has moved to imply the OCR could go as high as four per cent, or more.

None of the major banks see it going up that much, and some traders might argue we’ve already seen the highs in wholesale rates, with these lofty expectations in the price.

I can see why they’d be sceptical. At those levels it would mean a one-year mortgage rate above six per cent. That’s more than double the average rate of the past two years, and it would slow things down fairly quickly.

The Reserve Bank still has a bit of catching up to do, so the OCR is headed higher. However, the peak in medium-term interest rates could well be somewhere around current levels.

If that’s the case, from today’s starting point the investment opportunities and return prospects for fixed income investors have improved dramatically from a year or two ago.