Despite the situation being anything but normal, we have proceeded to do what humans do best: adapt and evolve – adjusting our lives to suit the changing environment. The question remains, however, if these adjustments will be in our long-term best interests.
Bonds have long been a mainstay of investors looking for income-generation, and higher interest rates certainly help in this regard. When you hear about people living on a “fixed income” this typically means they are relying either directly or indirectly on “fixed interest”.
For retirees, income-producing assets are crucial to helping them keep pace with the cost of living. Likewise, anyone drawing unemployment benefits or state pensions are drawing money from a pot effectively funded by the yields from Gilts and Treasuries and indexed to inflation.
With interest rates at all-time lows, the income from bonds has dwindled, and with “official” inflation being considered low, the indexing of state pensions is not keeping up with the real cost of living. And because interest rates are so low, the government pension pots are not growing at anything like the rates needed to be sustainable. This is why people dependent on fixed income have been feeling the pinch more than anyone else since the financial crisis in 2008, and why future retirees fear for the very existence of their state pensions.
Even though many of the most vulnerable savers are hurt by this low-rate environment, the banks absolutely love it. They bring in new money from depositors, to whom they pay almost zero interest, then loan that money out at a healthy profit.
But while banks can bolster their profits and buffer their reserves, the public do not enjoy the same luxury. Countless individuals have been encouraged by cheap borrowing costs to make decisions they would not normally have made, and find themselves with debts that can only be repaid if interest rates remain at historic lows. But when rates do inevitably rise, people who have “mortgaged their future” will suffer when their variable rate loans cause their monthly payments to increase beyond the limits of affordability.
The other people who will suffer from interest-rate hikes are investors. In a period of stock market uncertainty, people have been drawn to bonds because they are viewed as the low-risk, low-volatility alternative to other asset classes, like stocks for example.
Bonds and fixed income have provided steady capital appreciation for three decades because as interest rates have fallen, the value of the underlying bonds have risen. The experiences of investors over the past 32 years have seen them alter their investment behaviour, believing that what they have observed in the past will also work in the future.
But because interest rates have been moving steadily downward during that time, as we approach – or have possibly already reached – the end of a long-term secular bull market in bonds, the risk associated with investing in bonds will increase. When rates do finally rise, the economic world we inhabit will be a much different place.
The looming paradigm shift in global interest rates will affect just about everyone – directly or indirectly; knowingly or unknowingly. The size of the global bond market (sometimes referred to as the credit market) is a staggering US$100 trillion, with nearly US$1 trillion worth of bonds changing hands on a daily basis.
Consisting mainly of government bonds, corporate bonds, local authority or municipal bonds and mortgage-related bonds, it is significantly larger than the combined value of all global stock markets, which is why a change in rates will have such far-reaching global consequences.
It is highly recommended that investors scrutinise their current bond and fixed-income holdings. Whilst high grade, short-duration bonds can actually profit in times of woe, if you are invested in a bond fund that holds higher risk, higher yield – with lengthier average durations and lower quality holdings – you could well be in for a nasty shock should we enter a period of rising rates.
Such bonds and bond funds are actually more closely correlated to equity markets than other bond markets, so when a continued stock market sell-off results in a “flight to safety”, riskier assets such as high-yield bonds will face a “double whammy” in the ensuing sell-off.
There are many factors to consider when weighing up whether bonds are the right thing for you. If you would like to chat to us about the investing in bonds, drop us an email at: chatwithus@phuketexpatfinance.com