When conservative might not be so conservative

Many investors in conservative risk KiwiSaver funds or in fixed income funds might be a little surprised right now to see how some of their funds have lost value or exhibited more fluctuation in value than normal.

Paul Brownsey Paul Brownsey 3 minute read

OPINION: Many investors in conservative risk KiwiSaver funds or in fixed income funds might be a little surprised right now to see how some of their funds have lost value or exhibited more fluctuation in value than normal.

Some investors may think this is at odds with how a conservative risk fund should behave, but it’s actually not a surprise if we understand what is happening in financial markets.

Bonds are essentially a loan that an investor makes to governments, corporations or other borrowers.

They aren’t as risky as the equity in a company – for instance, most bonds have an agreed term and pay an agreed interest rate, usually in the form of semi-annual or annual payments.

If the borrower does not default on the bond, then the investor knows exactly what payments they are receiving for the life of the bond.

As an example, just this week the New Zealand Government borrowed $200 million for three years, paying an interest rate of just 0.5 per cent per annum.

So, interest rates, both in New Zealand and globally are very, very low – both in absolute terms and by historical standards.

The why is easy. Low interest rates help stimulate economic activity and because of economic growth concerns and Covid slowdowns, central banks around the world have actively forced interest rates lower.

They do this in two main ways: Firstly, by lowering the rate at which the central bank lends to the economy, and secondly by actively buying bonds which helps drive their yield lower.

Low yields are a good thing. They probably mean that the borrower has a good credit rating. Low rates also help the economy grow and companies be more profitable.

But low rates also have some negatives. Borrowers can borrow larger sums of money at the same cost – this can help push up property and asset prices. And, if rates are at historically low levels, what happens when they start rising?

The relationship between the price of a bond and its yield is negative. That means when the yield goes down, the price goes up, but more dramatically, when the yield rises, the price goes down.

As an example, think of our Government borrowing money right now at 0.5 per cent. If the borrowing rate rises to 1.5 per cent, all of a sudden, holders of the 0.5 per cent bond are feeling a little bit underwhelmed.

Instead of getting the current rate of 1.5 per cent, they are just getting 0.5 per cent. So, what happens is that the price of our 0.5 per cent bond has to fall until it is providing the same overall return as the 1.5 per cent bond.

The only way to make the math equivalent is for the price of the 0.5 per cent bond to fall until a buyer of it will get the same overall return as the buyer of the new 1.5 per cent bond. This would mean a fall of about 3 per cent in the value of our 0.5 per cent bond.

So globally, interest rates have been rising as investors and governments become more optimistic about a return to more normal economic growth conditions as we move out of the worst effects of the Covid pandemic-induced slowdown.

Conservative KiwiSaver funds usually hold a lot of bonds, and these prices are under pressure. Specialist bond funds are also feeling the pressure – just surveying websites of some New Zealand-based bond funds shows falls in recent months of over 5 per cent for some funds.

Is it time to panic? Definitely not. But it is a good time to do a risk assessment.

Speak to your fund provider or a financial adviser and just make sure you are thinking about the risks and that your savings are in the right home.

Any fund manager with bonds in their funds should be able to give you a clear description of how they are understanding and managing the risks from higher interest rates.

Paul Brownsey is chief investment officer at Pathfinder Asset Management, and KiwiSaver provider CareSaver. His views in this article are general only and are not recommendations for any particular person in relation to any share or financial product.

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