Unhappy returns for investors

When the sharemarket crashes, just about everyone notices, but dramatic moves in the fixed interest market often go unreported.

Yet for retired investors with a reasonable amount of their money in bonds and bank deposits, changes in interest rates tend to be much more significant in terms of cold, hard cash.

Falls in short-term interest rates frequently come as a shock to mum and dad investors. But they shouldn't be surprised, because there is a way of forecasting where short-term rates are heading: take a look at longer-term rates.

For example, the yield on five-year Government bonds can give us a clue to what interest rates will be one, two or three years from now.

In the past 18 months local short-term interest rates have been reasonably stable. All the action - locally, anyway - has been in longer-term rates.

Ten-year Government bonds have fallen from around 6.6 per cent to 5.12 per cent. In the past month alone, the yield on 2013 New Zealand Government bonds fell by 0.5 percentage points.

Overseas, where bonds running for 30 years or more are common, declines have been breathtaking.

In the United States the yield on 30-year Government bonds is the lowest it has been for 40 years - 4.17 per cent, compared with 4.82 per cent a month earlier.

For anyone who has already invested in those bonds, this is great news because, as yields fall, existing bonds become more valuable. The fall in the yield on US 30-year bonds means a capital gain of 8.32 per cent in a month.

That sort of movement suggests either that the bond market is irrational or that investors have perceived a major change in the investment environment.

It's also a bit ironic: various investment luminaries keep telling us to forget about high returns from the stockmarket and then low-risk bonds go and rise by almost 10 per cent in a month.

But what falling bond yields mean for most investors is that the cost of securing retirement income, by investing in fixed interest, is going up. In a particularly sobering piece of research, the economics team at London-based bank HSBC published their views on interest rates last month.

They believe that US rates will go much lower, and forecast that in a year US 10-year bond yields will be just 2.5 per cent, compared with today's 3.1 per cent.

In such uncertain times as these, many investors, and even some financial planners, react by avoiding shares and sticking the money in the bank.

I don't have the figures, but judging by the size of the outflows from share funds and the fact that the financial planning industry seems to have a lot of "spare capacity" at present, it is pretty clear lots of people are keeping their money in the bank, just in case disaster strikes.

This may not be all that clever, because history shows that when you have deflation - falling prices - the interest rate on short-term, low-risk deposits can fall almost all the way to zero. (US bank rates in the 1930s and Japanese bank rates now are two examples).

If the 1930s experience repeats itself, mum and dad with a $150,000 retirement nest egg and an income of $8000 a year from a 5.3 per cent bank term deposit could find themselves having to get by on a return of just 1 per cent, or $1500 a year. If that isn't a disaster, I don't know what is.

The smart money has stocked up on long-term high-quality bonds. Not the junk offering 8 or 9 per cent - most of those companies would be history in a severe recession because of their debt levels - but Government and state-owned enterprise bonds from organisations such as Transpower, Housing Corp and so on, whose ultimate owners can and would print more money if times get tough.

So, over the next couple of years, a key issue for many retired investors is likely to be the direction of short-term rates. And, as mentioned earlier, long-term rates give us a clue as to where the short rates will go. So, retirees, fasten your safety belts, this is not going to be good news.

The two issues that have a big effect on interest rates are the riskiness of the borrower and the term of the investment. The second issue, which sees the return on investments vary according to their maturity dates, is known as the "term structure of interest rates" or the "yield curve".

With a "normal" yield curve, short-term rates are lower than long-term rates. In those circumstances you'll get more for giving your money to the bank for three years than you will on a one-year deposit.

Economics has come up with several theories to explain why this is so. One is the expectations hypothesis, which simply says that any longer-term interest rate is the average of all the short-term rates which are expected to prevail over the longer term.

Another explanation, the liquidity preference theory, says because a longer-term bond is more risky than a short-term bond, investors require a higher interest rate.

In the real world, longer-term rates are generally higher than short-term rates. We know that long-term bond yields in New Zealand have fallen dramatically in the past year and we know that long rates should be higher than short rates, so we can try to determine what short-term interest rate the market is forecasting.

The maths involved in these sorts of calculations are a bit intimidating for this simple stockbroker, so I enlisted the help of Professor J. B. Chay of the University of Singapore. His analysis suggests that based on historic New Zealand data, "the extra return investors demand from a 10-year bond over a 90-day rate is about 2 per cent".

So, if long-term rates are now 5.1 per cent, either the bond market is out of control or the market expects short-term rates to fall to 3 per cent or so before too long.

If short-term rates really do fall to 3 or 4 per cent, or lower, there is likely to be a mad rush for higher yielding instruments like soundly leased property, property shares and shares in general, providing the coming slowdown is not too severe.

But by then it will probably be too late to move because the prices of those desirable investments will have already risen to reflect the demand for them.

Yield-hungry investors typically reject a 5 per cent interest rate as "too low" and opt for some higher yielding alternative. Such an approach could be quite disastrous in a global recession.

In such an uncertain environment, it is more critical than ever that retail investors managing their own fixed-interest portfolios have a mix of short, medium and long-term bonds with a majority in Government or SOE securities.

And just in case the bond market is a bubble and short-term interest rates actually rise rather than fall, make sure you have some exposure to property and shares which tend to do well in better economic climates.

And if you have a mortgage, a floating rate option looks the best bet.

* Brent Sheather is a Whakatane financial adviser.