Understanding Bonds and Fixed Interest
Fixed interest investments are often viewed as one of the more stable parts of an investment portfolio. They can provide regular income and generally have less volatility than shares.
However, fixed interest funds can still rise and fall in value. One of the main reasons is changes in interest rates.
Understanding how this works can help explain why a fixed interest investment can sometimes show a negative return, even when the underlying bonds continue to pay interest.
How does a bond work?
A bond is essentially a loan made by an investor to a government, bank or company.
For example, imagine you invest $10,000 in a bond paying 5% interest each year. You would receive approximately $500 in interest annually, and assuming the bond is held until maturity and the issuer meets its obligations, you would receive your $10,000 back at the end of the term.
The important point is that the interest rate on an existing bond is generally fixed.
So what happens when interest rates change?
Imagine you own a bond paying 5% interest, but interest rates subsequently rise and newly issued bonds are now paying 6%.
Your existing 5% bond is less attractive to another investor because they could buy a new bond paying 6%. The bond hasn't stopped paying its $500 interest. The change is in what someone is prepared to pay for the bond today.
As a result, if you wanted to sell your existing bond before it matures, you would generally have to accept a lower price.
When interest rates rise, the market value of existing bonds generally falls.
Conversely, when interest rates fall, existing bonds paying a higher rate become more attractive, so their market value generally rises.
This is why bond prices and interest rates generally move in opposite directions.
What does this mean for a fixed interest fund?
A fixed interest fund normally owns many different bonds, rather than one individual bond.
The fund manager may hold government bonds, corporate bonds, bank debt and other fixed interest investments, with different maturities and interest rates.
The value of the fund is based on the current market value of those investments. Therefore, when interest rates rise, the value of many of the bonds held by the fund can fall, causing the fund's unit price to decline.
Why higher interest rates can eventually be good news
When interest rates rise, bond prices generally fall in the short term. But over time, a fixed interest fund can reinvest maturing bonds at the higher interest rates. This means the fund can potentially generate a higher level of income in the future.
For investors with a longer-term investment horizon, the initial decline in value can therefore be partly or eventually offset by the higher income earned from newly purchased bonds.
The bigger picture
Fixed interest remains an important part of many diversified portfolios because it can provide:
Regular income
Diversification away from shares
Generally lower volatility than equities
A source of capital for investors who need to withdraw money
Greater stability within a portfolio
However, it is important to understand that “fixed interest” does not mean “fixed value.”
The value of a fixed interest fund can fluctuate from day to day as market interest rates, credit conditions and expectations about the economy change.
For long-term investors, short-term movements in bond prices need to be considered in the context of the overall portfolio and investment objectives.