Rebecca Howard: Backing bonds before rates go sub-zero

Rates are steadily heading downward. Photo / Getty Images

COMMENT:

Income and fixed interest funds are paradoxically back in vogue despite – or maybe because – the spectre of negative interest rates is hanging over markets.

InvestNow managing director Anthony Edwards has seen a big jump in demand for income and fixed interest funds in the past month.

"It's like someone flicked a switch. This is new demand from new investors," he said.
Around 15,000 people have invested $360 million in different funds through InvestNow. Of that, 13 per cent is in fixed interest and cash equivalent funds, up around 30 per cent since March.

Edwards puts the increase down to low bank term deposit rates spurring people to look for alternative places to invest.

The average one-year term deposit rate fell below 3 per cent in August, so what's changed?

Tamar Hamlyn, principal at Sydney-based Ardea Investment Management, puts it down to chatter – both in New Zealand and across the globe – about "zero bound" interest rates.
"Deposit rates have been low for a long time, but there seems to be something psychological about zero, that prompts perhaps some mild outrage among deposit holders," he said.

This "perhaps provides the impetus needed to make the effort to look at other alternatives, and this is a part of the flows into fixed income I believe."

Edwards agrees. "While long-term fixed interest yields have fallen in recent years, investors do get the benefit of locking in current rates. This will be beneficial if interest rates fall even further than where they are currently."

Peter McIntyre, investment adviser at Craigs Investment Partners, said term deposits look better but demand for bonds is strong. It all hinges on what you think is going to happen.
"If rates fall further, you're going to be okay by buying that bond, but if they stay static you may be better off just in a term deposit," he said.

The money is on rates falling further. The Reserve Bank's surprisingly big rate cut in August saw market interest rates tumble, with the September 2025 inflation-linked government bond the first local currency denominated asset to trade at a negative yield.

The central bank is widely expected to cut the official cash rate to 0.5 percent by early next year. It is doing preparatory work on unconventional policy tools such as negative interest rates in the unlikely event it needs them.

Against that backdrop, "the questions we are getting asked suggests there is aggressive demand for higher income products," said Grant Hassell, global head of fixed income for AMP Capital.

Smartshares director for institutional clients, Thom Bentley, said the belief that rates will go even lower combined with tame inflation "makes a fixed income stream more attractive."

Fears that recent stellar returns on equities may have peaked might also be pushing investors into the safe haven of fixed income.

Salt Funds Management managing director Matt Goodson said stocks are "absolutely" top heavy but that's not denting the hunt for yield. "There is clearly significant money flowing into equities that would perhaps not otherwise be invested in equities," he said.

Excluding property companies and Infratil, the forward price-to-earnings ratio is over 34 times, he said. The median, however, is only 18.5 times.

Goodson noted the NZX50's top 10 stocks are up around 26 per cent over the past year and the next 10 by around 16 per cent. The other 30 are down on average.

There are also fears that equities have reached their limit. Photo / Getty Images

He puts that down to the impact of passive investing. "Given the small size and limited liquidity, our market has been disproportionately affected by the global trend from active toward passive," he said.

"It's a ticking time bomb that's been stored up" because there will be an outflow at some point. He blames monetary policy.

"Central banks have actually created quite some risk of a financial shock at some point. With this move to very low rates, they have forced people into equities."

As the equity bull-run slows down, Goodson expects "people will be disappointed" with total returns in the future.

His concern is shared by the International Monetary Fund, which noted in its latest global financial stability report the low rate environment has created "further incentives for investors to search for yield, leading to stretched valuations in some asset markets."
Cheap finance has "fuelled a further build-up of financial vulnerabilities."

AMP's Hassell warned that local history is littered with examples of people chasing any amount of risk provided they get the chance of a higher return.

Some fund managers are rejigging their fixed income funds to chase a higher return by increasing the credit or payment risk, he said. That can be by lending to entities with lower credit ratings than the government, increasing the term to tap into longer-dated yields, or taking on assets that are harder to sell.

All of those are fine "as long as people know what they are investing into," he said.