Jarden Wealth Weekly: Why bonds are back

The place for bonds is looking stronger than ever now.

OPINION

The global challenges - and the financial consequences - of recent years are well known, and the events are still coming thick and fast.

Wars, extreme weather events, rising fuel prices, (TMO interventions in the rugby), you name it.

In this environment it has been challenging to make your money grow. Even the “safe haven” of the bond market has been affected.

New Zealand government bonds are close to an unprecedented third consecutive year of negative returns and corporate bonds have experienced subdued returns.

But, given the dramatic increase in interest rates and the current economic climate, it may be time for bonds to take centre stage – or at least get some of the spotlight back.

Back to basics

Bonds are a fixed interest security. By buying a bond you are effectively lending money to an entity which could be the government, local councils, or corporates.

They will pay you interest (the coupon) typically for a set number of years and then return your money to you on the agreed date (maturity date).

The length of the investment period and the interest rate are set when the bond is issued. The interest rates on offer have increased materially over the last two years. In return for the flow of income and the expectation of getting your money back, you are taking on the risk that the borrower remains creditworthy, can maintain the regular payments and will have the funds available to repay on maturity.

This is why, in New Zealand, the lowest risk bonds – and thus lowest yielding - are government-issued.

In this scenario, your money is only at risk if the Government has run out of money to pay its debts. And so, all being well, you will receive your money back on maturity.

Where it gets interesting is the enormous market for trading bonds, giving you the option to sell them at any time.

If you decide to sell your bonds before maturity, you may find that you make a gain, or a loss, as it gets priced “marked to market”.

If interest rates have moved lower, you will make a gain, as your interest rate is better than those currently on offer.

This gain is amplified by the number of years remaining with that higher interest rate. The flipside is true of rising interest rates.

In New Zealand we saw the Official Cash Rate (OCR) hurtle up from a trough of 0.25 per cent in September 2021 to 5.5 per cent by May this year.

The speed of such an unprecedented increase - which has been mirrored around the world – meant that bonds purchased when interest rates were abnormally low, have dropped in value.

Why did Interest rates rise so sharply?

Economists will argue for years to come about the root cause of the current situation, and it certainly goes back decades but in terms of the most recent events, the Covid-19 pandemic was a major influence.

It led to an unprecedented easing of monetary policy as governments rushed to help people and businesses survive the cost of the seemingly endless lockdowns, which in turn led to surging inflation in many countries as the supply of goods was disrupted at the same time as demand spiked with millions of people shopping online, bankrolled by massive government handouts.

The Russia-Ukraine conflict added fuel to the fire, spurring a sharp rise in energy prices and more inflation.

Once the world opened back up, the fear of escalating inflation drove central banks to increase interest rates at unprecedented speed in efforts to slow their economies, with the expectation that this will lead to cost pressures easing.

There are signs in New Zealand and globally that this is starting to work but it does take time for the increases to be felt and for behaviour to change, hence why most central banks are still talking hawkishly and keeping the pressure on.

Is there risk?

Yes. As mentioned, you get your money back if the entity you effectively lent money to is in a position to repay. Which is why unless clients are willing to take on increased risk, we tend to look for high-quality bonds like those issued by the Government, utility companies or banks, which have been assessed with a strong credit rating.

The other consideration with risk is the “marked to market” element mentioned earlier.

The value of the bond will constantly be changing (just as the value of your home does, the difference being that bond prices are more visible).

But we are in a very different place in terms of the interest rate cycle now. Back in late 2021, 27 per cent of global investment-grade bonds were subzero!

Now there are yields readily available over 5 per cent.

There is still scope for interest rates to rise, but there is now much more room for them to come back down over the next few years with unemployment expected to increase, inflation moderating and central banks potentially starting to think about encouraging growth again.

In this case the dynamics that have created the negative returns on bonds could well reverse as we reach peak interest rates, making a gain (in addition to your coupon interest) possible.

Simply put, if you buy a six-year bond paying 6 per cent and interest rates fell by, say, 1 per cent in the next two years, then that bond will be paying 1 per cent over market rate for the last four years of the bond and the bond’s price will increase to reflect the above market yield.

So bonds are back?

While a diversified portfolio should always have a place for bonds, there have been numerous articles questioning the benefit of including bonds in such strategies in recent years.

But the place for bonds is looking stronger than ever now.

Mark Logan is wealth management adviser at Jarden.

Jarden Securities Limited is an NZX Firm. A financial advice disclosure statement is available free of charge at https://www.jarden.co.nz/our-services/wealth-management/financial-advice-provider-disclosure-statement/.

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