OPINION: Investors want somewhere relatively safe that delivers good returns. Right now that’s hard.
New Zealand and US share markets are close to all-time highs, yet the global economy is in recession.
Bank deposits are thought of as secure, yet deposit rates are at ludicrously low levels. How does a one-year bank deposit at 1.25 per cent sound?
Shares may well go higher, but the brutal fall in March is a reminder they can go down as well as up.
At times like these, many investors look at alternative options, including bonds. Bonds, like shares, are issued by companies, governments or banks.
While shares record ownership in the issuer, bonds essentially record a loan. They can pay a fixed interest rate for a fixed term and then return your investment.
While a bond sounds a lot like a bank deposit, they are not the same. Bonds can be traded (bought and sold) and the value can go up and down.
In fact, the price can change significantly.
In December 2015 Spark issued an eight-year bond with a 4.51 per cent per annum interest rate.
Today anyone would be very happy with 4.51 per cent per annum for the remaining two-and-a-half years until maturity.
Over recent years the price of the Spark bond increased to reflect lower interest rates in the market.
The market interest rate is now 0.86 per cent, which explains why the Spark bond value is currently $109.
This means if you buy the bond today for $109, at maturity you will get back just $100.
You will also receive interest of 4.51 per cent per annum.
Overall your return will be a meagre 0.86 per cent per annum.
An alternative, with different risk, would be to buy Spark’s shares with an expected dividend yield of 7 per cent over the next year.
Bond values go up as interest rates come down. But the opposite is also true. Bond values fall as interest rates rise.
Bonds can be very risky in an environment where interest rates may go up. The tailwind from interest rates going down is largely exhausted.
Around US$15 trillion (NZ$16.4tr) of bonds globally are trading on negative interest rates.
If it sounds crazy, that’s because it is.
These are mostly government bonds, but increasingly corporate bonds also.
You pay for someone to hold your money. It’s like making a deposit with your bank and paying them.
In New Zealand, interest rates are low, but not negative. It’s possible our Reserve Bank may set its official cash rate below zero, but no one, including them, wants deposit rates to go negative.
Bonds are traded and can go up and down in value. Over the next five years they are more likely to fall in value than rise.
Bonds react directly to interest rate moves. If rates rise, bond values fall. As a rough guide, if you have a 5-year bond and rates rise by 1 per cent, your bond will lose 5 per cent in value. A 10-year bond will have a 10 per cent loss for every 1 per interest rates rise. This introduces risk for bonds right now as we are unlikely to see many more interest rate cuts.
Globally a ridiculous number of bonds are trading on negative yields. We are unlikely to see this in New Zealand. Our bond rates are low, but thankfully not negative.
John Berry is chief executive at Pathfinder Asset Management, and KiwiSaver provider CareSaver.