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Interest rate hikes: Is your portfolio really conservative?

As a period of record low interest rates draws to a close, bond investors may be in for more short term pain said Hamesh Sharma, portfolio manager at Pathfinder.

HAMESH FINAL sq Hamesh Sharma 3 minute read

With the Reserve Bank raising the official cash rate back to 0.75 per cent and indicating it is firmly in an interest rate hiking cycle, it seems this period of record low interest rates is now behind us.

Most of the headlines have focussed on the potential impact on residential property prices given the flow on effect of higher mortgage rates, and other assets such as shares.

However, the asset class directly impacted by moves in market interest rates is fixed income assets, such as bonds. Bonds are essentially debt, which can be issued by a company or country, at a fixed or variable interest rate, for a stated period until the bond matures and the debt is repaid to the investor.

If market interest rates fall, the market price of a bond goes up as its fixed interest rate which was set earlier now looks more attractive. Conversely, if market interest rates rise, the bond price will fall as investors will see the interest rate paid on the bond as inferior to the new market rate.

Interest rates globally have been in a steady downtrend since the 1980s, a time when some readers may remember 16 per cent mortgage rates.

As a result, bond investors have enjoyed a large tailwind in terms of return, with very few moves against them in terms of negative price fluctuations. However, this may be changing in 2021.

In what could only be described as a truly remarkable month, October 2021 saw the New Zealand two-year interest rate jump 0.87 per cent. While this may not sound like a lot it is in fact the largest one month move since 1999.

Bond funds have been popular with investors but the move higher in interest rates over 2021 has seen returns of NZ bond managers come under huge pressure. Investors often think bonds can’t lose money but over the last 12 months three of the largest NZ bond funds are down between 8.5 per cent and just over 10 per cent.

Bonds funds have been thought of as a safe and conservative investment, so many investors in these funds have probably experienced losses they did not even know were possible.

But it’s not just investors in NZ bond funds who are taking a hit, investors in conservative KiwiSaver funds have probably noticed their balances have been treading water or are down in recent months.

This is because most conservative KiwiSaver Funds by their nature and design have a large allocation to bond markets, especially NZ bonds, which have experienced losses.

At Pathfinder, we have made an active decision to be underinvested in listed bonds. Check how your KiwiSaver manager has positioned their fixed income allocations as some managers have definitely done a better job than others coping with rising interest rates.

In summary, supportive actions by central b nks globally and the Reserve Bank here in New Zealand have seen both bonds and shares go up in value at the same time.

With interest rates looking like they are finally on the rise, this goldilocks relationship may no longer hold over the near term and bond investors may be in for more short-term pain. The message for investors is to check your savings are invested with the risk of higher interest rates in mind as investing in long term bonds is no longer the easy one-way bet that it has been for so long.

Hamesh Sharma​ is a portfolio manager at ethical fund manager and KiwiSaver provider Pathfinder Asset Management, which is part of Alvarium Wealth.

(This article was originally published by Stuff December 2, 2021) 

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