What is fixed interest? Many investors have a fixed interest investment as part of their portfolio, yet many know very little about the asset class. You may have a term deposit with a bank or an investment in government bonds, mortgages or hybrids – either directly or through a managed fund. The purpose of this article is to help investors understand fixed interest investments and how they may fit into a well-diversified investment portfolio. Fixed income refers to a variety of debt instruments, although is most commonly associated with bonds. A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending money to a government, semi-government, corporation, or other entities known as an issuer. In return for that money, the issuer provides you with a bond in which it promises to pay a specified rate of interest(coupons) during the life of the bond and to repay the face value of the bond (the principal) when it matures, or comes due. This is where the term Fixed income comes from, the rate of return or income generated from the bond is usually fixed, however the capital return is only fixed if a bond is held to maturity.
Interest rate Bonds pay interest that can be fixed or floating. Most debt securities carry an interest rate that stays fixed until maturity and is a percentage of the face (principal) amount. Fixed rate bonds carry any interest rate that is established when the bonds are issued (expressed as a percentage of the face amount) with semi-annual interest payments. For example, a $1,000 bond with an 8% interest rate will pay investors $80 a year in payments of $40 every six months. This $40 payment is called a coupon payment. When the bond matures, investors also receive the full face amount of the bond, $1,000. Some issuers, however, prefer to issue floating rate bonds, the rate of which is reset periodically in line with interest rates on Bank Bills, the RBA Cash Rate, or some other benchmark interest rate index. Depending on the prevailing interest rate environment, investors tend to favour one over the other. We will explore the impact of interest rates on the different types of bonds in more details below.
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Yield A bond's yield is the return earned on the bond, based on the price paid and the interest payment received. Usually, yield is quoted in per cent. There are two types of bond yields: current yield and yield to maturity (or yield to call). Current yield is the annual return on the dollar amount paid for the bond and is derived by dividing the bond’s interest payment by its purchase price. If you bought a $1,000 bond at par and the annual interest payment is $80, the current yield is 8% ($80 / $1,000). If you bought the same bond for $900 and the annual interest payment is $80, the current yield is 8.89% ($80 / $900). Current yield does not take into account the fact that, if you held the bond to maturity, you would receive $1,000 even though you only paid $900. Yield to maturity is the total return you will receive by holding the bond until it matures. This figure is common to all bonds and enables you to compare bonds with different maturities and coupons. Yield to maturity equals all the interest you receive from the time you purchase the bond until maturity, including interest earned plus any gain or loss of principal. Yield to call is the total return you will receive by holding the bond until it is called – or paid off before the maturity date – at the issuer's discretion. In many cases, an issuer will pay investors a premium for the right to call the bonds prior to maturity. Yield to call is calculated the same way as yield to maturity, but assumes that a bond will be called and that the investor will receive the face value of the bond plus any premium on the call date.
The link between price and yield From the time a bond is originally issued until the day it matures or is called, its price in the marketplace will fluctuate depending on the particular terms of that bond as well as general market conditions, including prevailing interest rates, the bond's credit and other factors. Because of these fluctuations, the value of a bond will likely be higher or lower than its original face value if you sell it before it matures. In general, when interest rates fall, prices of outstanding bonds with higher rates rise. The inverse also holds true: when interest rates rise, prices of outstanding bonds with lower rates fall to bring the yield of those bonds into line with higher interest-bearing new issues. Take, for example, a $1,000 bond issued at 8%. If during the term of that bond interest rates rise to 9%, it is expected that the price of the bond will fall to about $888, so that its yield to maturity will be in line with the market yield of 9% ($80 / $888 = 9.00%). When interest rates fall, prices of outstanding bonds rise until the yield of older bonds match the lower interest rate on new issues. In this case, if interest rates fall to 7% during the term of the bond, the bond price will rise to about $1,142 to match the market yield of 7% ($80 / $1,142 = 7.00%).
The link between interest rates and maturity Changes in interest rates do not affect all bonds equally. Generally, the longer a bond's term, the more its price may be affected by interest rate fluctuations. Generally investors will expect to be compensated for taking that extra risk. This relationship can best be
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demonstrated by drawing a line between the yields available on similar bonds of different maturities, from shortest to longest. Such a line is called a yield curve. A yield curve could be drawn for any bond market but it is most commonly drawn for the Australian government market, which offers bonds of comparable credit quality for many different terms. Chart: Australian Government Bond Yields
. Source: RBA
A normal yield curve would show a fairly steep rise in yields between short and intermediate-term issues and a less pronounced rise between intermediate and longterm issues. This curve shape is considered normal because, usually, the longer an investment is at risk, the more that investment should earn. This can be seen in the green or purple lines representing 2010 and 2011 yields curves above. The yield curve is said to be steep, if the yields on short-term bonds are relatively low when compared to long-term issues. This means you can obtain significantly increased bond income (yield) by buying a longer maturity than you can with a shorter maturity bond. This can be seen in the red line above representing the yield curve in 2009. On the other hand, the yield curve is flat if the difference between short and long-term rates is relatively small. This means that there is little reward for owning longer-dated maturities. When yields on short-term issues are higher than those on longer-term issues, the yield curve is inverted. This suggests that investors expect interest rates to decline in the future and/or short-term rates are unusually high for some reason, e.g., a credit crunch. An inverted yield curve is often indicative of a recession. This can be seen in December 2007, where subsequently we entered the GFC. As a bond investor, you need to know how bond market prices are directly linked to economic cycles and concerns about inflation and deflation. As a general rule, the bond market, and the overall economy benefit from steady, sustainable growth rates. Moderate economic growth such as this benefits the financial strength of governments,
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semi-governments and corporate issuers which, in turn, strengthens the credit of those bonds you may hold. But steep rises in economic growth can also lead to higher interest rates because, in response, the Reserve Bank may raise interest rates in order to control inflation and slow growth. An increase in interest rates will erode a bond’s price or value. Fear of this pattern is what causes the bond market to fall after the government releases positive economic news, for instance about job growth or housing starts. Since rising interest rates push bond prices down, the bond market tends to react negatively to reports of strong and potentially inflationary, levels of economic growth. The converse is also true: negative economic news may indicate lower inflation and expected interest rate cuts and, therefore, may be positive for bond prices.
Default Default is the failure of a bond issuer to pay principal or interest when due. Defaults can also occur for failure to meet obligations unrelated to payment of principal or interest such as reporting requirements or when a material problem occurs for the issuer, such as bankruptcy. Bondholders are creditors of an issuer, and therefore, have priority to assets before equity holders (eg shareholders) when receiving a payout from the liquidation or restructuring of an issuer. When default occurs due to bankruptcy, the type of bond you hold will determine your status.
Capital Structure Same issuer, different credit risk
Senior Debt
Subordinated Debt
Hybrid Capital
Equity
Secured bonds are bonds backed by collateral. If the bond issuer defaults, the secured debt holder has first claim to the posted collateral.
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Unsecured bonds are not backed by any specific collateral. In the event of a default, bond holders will need to recover their investment from the issuer. Unsecured debt will generally offer a higher interest rate than those offered by secured debt due to a higher level of risk. Some bonds, such as senior bonds, have priority in making claims over those who hold subordinated bonds; a subordinated bond will typically offer a higher interest rate due to the higher level of risk.
Credit Quality The array of credit quality choices available in the bond market ranges from the highest credit quality sovereign bonds, which are backed by the full faith and credit of various governments (including the Australian and US governments), to bonds that are below investment grade and considered speculative, such as bond issues by a start-up company or a company in danger of bankruptcy. Since a bond may not reach maturity for years to come, credit quality is an important consideration when evaluating investment in a bond. When a bond is issued, the issuer is usually responsible for providing details as to its financial soundness and creditworthiness. This information can be found in a document known as an offering document, official statement or prospectus, which is the document that explains the bond's terms, features and risks that investors should know before investing. This document is usually provided by your investment advisor and helps an investor evaluate whether the bond issuer will be able to make its regularly scheduled interest payments for the term of the bond. While no single source of information should be relied upon exclusively, rating agencies, securities firms and bank research staff monitor corporate, government and other issuers' financial conditions and their ability to make interest and principal payments when due.
Credit Ratings The major rating agencies include Moody’s Investors Service, Standard & Poor’s Corporation and Fitch Ratings. Each of the agencies assigns its ratings based on analysis of the issuer’s financial condition and management, economic and debt characteristics, and the specific revenue sources securing the bond. The highest ratings are AAA (S&P and Fitch Ratings) and Aaa (Moody’s). Bonds rated in the BBB/Baa category or higher are considered investment-grade; bonds with lower ratings are considered high yield, or speculative.
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Lower ratings are indicative of a bond that has a greater risk of default than a bond with higher ratings. It is important to understand that the high interest rate that generally accompanies a bond with a lower credit rating is being provided in exchange for the investor taking on the risk associated with a higher likelihood of default. The rating agencies make their ratings available to the public through their ratings information desks and online through their respective websites. In addition, their published reports and ratings are available in many local libraries. Rating agencies continuously monitor issuers and may change their ratings of such issuers’ bonds based on changing credit factors. Usually, rating agencies will signal they are considering a rating change by placing the bond on CreditWatch (S&P), Under Review (Moody’s) or on Rating Watch (Fitch Ratings).
This information has been prepared by BT Investment Management (RE) Limited (BTIM) ABN 17 126 390 627, AFSL No: 316 455. This information has been prepared without taking into account any recipient’s personal objectives, financial situation or needs. Because of this, recipients should, before acting on this information, consider its appropriateness having regard to their individual objectives, financial situation and needs. This information is not to be regarded as a securities recommendation. This information is for general information only and should not be considered as a comprehensive statement on any of the matters described and should not be relied upon as such. It is given in good faith and has been derived from sources believed to be accurate as at its issue date. This may include material provided by third parties. Neither BTIM nor any company in the Westpac Group gives any warranty for the accuracy, reliability or completeness of the information in this document or otherwise endorses or accepts responsibility for this information. Except where contrary to law, BTIM intends by this notice to exclude all liability for this material. BT® is a registered trade mark of BT Financial Group Pty Ltd and is used under licence.
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