Personal finance and investing columnist at the NZ Herald

Brent Sheather: The interest rate sword of Damocles

If you believe the industry rhetoric, the Sword of Damocles hanging over investors is the threat of rising interest rates. Photo / Thinkstock
If you believe the industry rhetoric, the Sword of Damocles hanging over investors is the threat of rising interest rates. Photo / Thinkstock

If we are to believe the rhetoric from much of the investment industry i.e. financial advisors, stockbrokers and fund managers, the Sword of Damocles hanging over investors at present is the threat of rising interest rates. In fact many advisors are so enamoured with this scenario that they view it as a certainty that will devastate bond portfolios.

Accordingly the more radical advisors are telling clients not to own any bonds at all. One or two have even gone into print to that effect.

That this position is ridiculous, not to mention reckless for just about anyone let alone a retired individual, is evident when we consider three facts, as opposed to biased opinions, predictions and stabs in the dark:

• For at least the last 30 years NZ pension funds have averaged a 40 per cent weighting in bonds and there is no indication that they are today switching to shares en masse.

• Overseas pension funds have increased their weightings to bonds in the last five years and the latest edition of Pension Fund Indicators sees this trend slowing but not reversing.

• Last, but certainly not least, no one knows the direction of interest rates and given that the US bond market is the most liquid financial market in the world it's a big call to say that the collective view of the market, as expressed by the 10 year treasury yield, is wrong.

Before we get down to business today let's also acknowledge that the investment industry, as defined above, is in the business of selling risk, promising an inflated return premium, then pocketing most of said risk premium in fees. Given this business model low-risk bonds are the antithesis of a high margin portfolio and quite incompatible with the industry average annual fee structure.

Right, our cards are on the table and we will now proceed to Dispatch The Bogey Man Of Rising Interest Rates.

As the attached graph shows interest rates in the US and, because just about everything is priced off 10 year treasuries, the rest of the world too, are at historically low levels. This doesn't however mean interest rates must rise anytime soon but of course they might.

So let's buy into the scare tactics and confront the implication of a rise in rates on bond portfolios. Thanks to some typically useful, unique and counter cyclical research from US fund manager Vanguard we will see that rising interest rates need not be, for bond portfolios anyway, "the end of the world as we know it". In fact, recall that the 2013 iteration of the Global Investment Returns Yearbook suggested that rising interest rates might hurt shares as much as bonds.

In the report produced by Vanguard Australia they quantify the impact of rises in interest rates of various degrees over the entire curve as it would impact the Australian benchmark bond index, the UBS Composite Bond Index.

Their results are detailed in the attached graph and they confirm that the immediate impact of a rise in interest rates would be for bond portfolios to indeed fall in value.

However, stay invested for a further 12 months and only the 2 per cent upward move would result in a negative return and that would be just minus 2.5 per cent. If you hold the investment for a further year all returns would be positive. Hold for five years and total returns over the five years are actually higher the greater the move in interest rates. Why is this? The answer is simply that "over the long term interest income accounts for the largest portion of returns for many bond funds. The impact of price fluctuations can be more than off-set by staying invested".

Vanguard conclude that most long term investors should not view a bond bear market with the same level of apprehension as an equity bear market. "A bubble like scenario as we have previously seen in sharemarkets is not really possible in the bond market due to the guaranteed and fixed future cash flow".

Now that data was for Australia and specifically for the UBS Composite Bond Index but it has much relevance to NZ because Australian government bond yields are similar to our own.

Note also that the UBS Index has an average duration of 4.02 years. Duration is important because the longer dated the bond the greater the impact of changes in interest rates. So Mum and Dad with all their money in long term bonds would take a big hit from a 2 per cent rise in interest rates.

We calculate that the NZ government bond maturing in 2023 would fall immediately by 14 per cent if interest rates rose by 2 per cent. Conversely a portfolio invested in short dated bonds would suffer virtually no loss from a rise in interest rates. Recall that a sensible person owns short, medium and long bonds so the comparison with the UBS Bond Index is appropriate.

What is more even Vanguard's scenario is probably conservative because frequently a rise in short term interest rates is accompanied by a fall in long term rates because the market discerns that the impact of higher short term rates will be to constrain inflation further out. The main point however is that rising interest rates are not to be feared by most Mum and Dad investors with properly diversified bond portfolios and certainly are not a reason to avoid including an appropriate weighting to bonds as part of a balanced portfolio.

Contrast Vanguard's intelligent, calculated and responsible approach to this issue with the mis-information frequently promulgated at advisor conferences and CPD events and the pro-cyclical selling strategies of fund managers.

Everybody is crazy on shares at the moment so fund managers adopt a pro-cyclical approach and give investors what they want even if it isn't always in their best interest. Vanguard have a long track record of a more responsible approach to product advertising. I remember when the high yield bond market got overheated ten years or so ago Vanguard closed their high yield mutual fund to further money.

The original members of the Code Committee who had responsibility for ensuring that AFA's are a) trained properly, b) stay up to date, c) act ethically and give good advice, should reflect on why retail investors need to rely on Vanguard to inject some realism into a discussion of the dynamics of the bond market.

How on earth can we reconcile the anti-bond chorus so pervasive in the industry with the reality as detailed by Vanguard and why doesn't reading the Vanguard report give an advisor structured CPD credits? The answer is clear.... any research that isn't good for business is simply not taught with the result that much of the training and CPD is rubbish which does more harm than good. As Gareth Morgan said at the time the process was "captured" by industry and everybody is a winner except investors.

- NZ Herald

Brent Sheather is an Authorised Financial Advisor.

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Personal finance and investing columnist at the NZ Herald

Brent Sheather is an Authorised Financial Adviser and personal finance and investments writer

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