Martin Hawes on how fixed interest works

Martin HawesMartin Hawes
Chair, Summer Investment Committee


Fixed interest investments are often called bonds. It sounds such a safe word for an investment based on a solemn promise (my word is my bond); an investment that could not possibly go wrong. In fact, fixed interest investments are often called bonds because the borrower promises to repay the money it has borrowed with interest at a future date.

To underline this sense of promise and stability, some of the old bond certificates were beautifully engraved, almost works of art (I have a collection of framed antique bond certificates on my walls at home).

Generally speaking, fixed interest as an asset class is one of the safest investments. A fixed interest investment is a solemn promise and borrowers are as careful as they can to repay the money that they have borrowed. That is good for those who lend the money – investors are probably likely to get their money back but also the agreed rate of interest.

There are lots of different types of fixed interest investments, but they typically have the following features:

  • They are for a set period of time (often six to ten years).
  • They attract an agreed rate of interest or coupon which is usually fixed until maturity.
  • The borrowers are usually large, relatively stable and tend to be well known entities: Governments (including Local Authorities), banks and corporates.
  • The borrowers often have a credit rating from one of the rating agencies (e.g. Standard and Poors, Moodys, Fitch). This may be one way for investors to assess the risks that they are taking when they buy into a fixed interest investment – i.e. the likelihood of default by the borrower.
  • The lenders, or the buyers of the bond, may be fairly small retail investors (the minimum investment is often $10,000) but they could also be very large investors (KiwiSaver funds or corporate investors).

These features sound like fixed interest investments are very similar to term deposits but they do have one important difference: most fixed interests do not have to be held to maturity – they can be sold (and bought) on the stock exchange or directly with other intermediaries such as banks (this is called the secondary market).

This means that if an investor took a ten-year fixed interest investment, he or she could, through a broker or other intermediary, sell the investment after (say) three years. Investors can usually cash up their fixed interest investments by selling them as and when they need. (Of course, this also means that new investors can buy on the secondary market if they want a particular fixed interest security).

But if things change, the selling becomes different, you may not get back the amount that you put in or the amount you expect to get. This is because you are selling your fixed interest investment early. If you hold it until maturity as many small investors plan to do, you will usually get your money back when the term expires (unless something goes very wrong with the borrower). However, when you sell early on the secondary market, you are selling on the open market and you will get what other investors offer.

This could be more or less than you put in. The amount that you will be able to sell for depends on a range of factors, but the three main ones are:

  • The creditworthiness of the borrower changes. If the credit rating of the borrower has improved, it is likely that your fixed interest investment will maintain its value; but if the rating has deteriorated, you will get less. Remember that fixed interest investments are for a long period of time and changes can and do happen. This is one reason why Government fixed interest investments are so sought after – they tend to be very stable and can most usually meet their obligations.
  • Interest rates change. If you buy a fixed interest investment for 10 years at 4% and interest rates rise, you are stuck at that level – no-one will buy your bond at what you paid for it if they can get 5% just as safely elsewhere. The market will, therefore, pay less for your investment so that the new investor can effectively get the higher rate. On the other hand, if interest rates fall to (say) 3%, you are locked in at a rate higher than the general market and people should agree to pay more for this investment.
  • The time remaining until maturity affects the value of a bond. Often, longer-term interest rates are higher than shorter-term rates. The higher interest rate for a longer time to maturity compensates investors for the additional risk that they take when committing money for a long period (the longer the time to maturity the more chance of something adverse happening that could affect the bond, after all, who can accurately predict the future?). In this case (and other things being equal), as the time to maturity decreases, a new investor buying your bond may be happy with a lower interest rate.

If you think about it, fixed interest investments are for three main groups: first, those who think there may be a fall in interest rates. Such people will benefit because they have locked in a higher rate and also because they will get a capital gain (although, unlike shares and property, this capital gain is generally taxable, if realised).

Second, those who want certainty of income. These people may live on interest and they need to be sure that they will have sufficient income.

And third, those people who are unsure what the future holds, so want to hold a certain amount of more stable investments in order to offset their more volatile investments, such as shares.

The Summer KiwiSaver Investment Committee’s current view is to stay under-weight to fixed interest at the moment. Indeed, the Summer Investment Selection has currently allocated 25% of the portfolio to New Zealand fixed interest against a total target (New Zealand and international) of 30%. This is because we think that interest rates are more likely to rise than they are to fall, this is especially our view for international bonds. Our exposure to fixed interest, which currently doesn’t include any overseas bonds, has been one of the reasons that the fund has done well against other funds over the last year.

Overall, fixed interest investments are generally safer than shares. In the event of financial trouble, investors who have lent money to a company are repaid before shareholders. Fixed interest does show some volatility (the price on the market does go up and down) but nothing like as much as shares. Why not check out the risk indicators for our Summer funds? We explain how they work in our monthly performance summaries and quarterly fund updates. In any event, if you chose a good solid fixed interest issuer (especially a Government or bank) and decide to hold through to maturity, you are most likely to receive all of your interest payments and get your capital back at the end of the term.

 

You might like to discuss the views in this article with your Authorised Financial Adviser. Please call your Adviser directly or toll free on 0800 11 55 66.

Read more about My Plan and the Summer Investment Selection.

Like to learn more about investment mix? Watch Martin's video on asset allocation.

If you are interested in other investor education insights from Martin visit the Media Investor Education page.

Martin Hawes is an Authorised Financial Adviser. This is not a recommendation to buy or sell any financial product and does not take your personal circumstances into account. All opinions reflect our judgement on the date of communication and may change without notice. Past performance is not a reliable guide to future performance. We recommend you take financial advice before making investment decisions. We have prepared this web page in good faith based on information obtained from other sources, but we do not guarantee the accuracy of that information. We do not make any representation or warranty (express or implied) that this web page is accurate, complete, or current and to the maximum extent permitted by law disclaim any liability for loss which may be incurred by any person relying on this web page.