With interest rates expected to rise, a shorter-term portfolio could be the best strategy.
When the Reserve Bank lifts interest rates late this year or early next, it will possibly be the first such move by a central bank anywhere in the developed world.
Traders are betting Australia’s central bank will cut its cash rate in the next 12 months as investment in its mining boom peaks and the rest of its economy fails to do enough to take up the slack. In the US, Europe and Japan, central banks will need to take a range of unusual measures, such as quantitative easing, before they can consider lifting interest rates from record lows.
But it is hard to find a professional investor who doesn’t think interest rates are set to rise everywhere – eventually. US 10-year Treasury yields reached a record low of less than 1.4% in July last year and have since climbed back to 2%. New Zealand government yields have also climbed from their lows of 2012. It would take a nasty and unexpected deterioration to push yields substantially lower again.
“Given yields are so low at the moment and it looks like the world is coming out of repair phase and into growth phase, it’s time for investors to ask why they are in this asset class,” says Grant Hassell, who oversees $8 billion of investors’ cash at AMP Capital New Zealand.
“The risks have gone up,” he says. “The chances of getting very low or negative returns have increased.”
AMP Capital is underweight on bonds and overweight in growth assets for 2013. Its returns from New Zealand stocks last year averaged 28% and global shares, hedged, returned about 20%. In contrast, New Zealand bonds returned a mere 6.3% and global fixed income 5.6%.
For New Zealanders, especially older ones reliant on investments for income, the current landscape looks a bit miserable unless they’re prepared to take on greater risk. Money on term deposit for 12 months is earning an average of 4.2%, meaning $1 million invested will generate just $42,000 a year.
And the opportunities to buy the sort of NZX-listed bonds offered to retail investors are fading. Auckland Council was the last issuer back in December, selling $125 million of six-year bonds paying 4.41% interest.
And this lack of opportunity provides a dilemma for the investor schooled to build a balanced portfolio.
“We’re in a situation where there is not much new activity and not much in the secondary market,” says Direct Broking’s David Speight. “People need to be patient and not sacrifice their tolerance for risk. It is not necessarily something you can build overnight.”
He suggests retail investors wanting to invest in bonds should make sure they’re on alert lists for new issues. They should check the quality ranking (from high-security senior secured debt to lower-quality unsecured, unsubordinated or subordinated debt) and what options the issuer has on maturity or earlier. A callable note means the issuer can decide when it pays back the money.
When interest rates are going up, the best strategy is to have a shorter-term portfolio; longer-term is better when rates are falling. If the direction isn’t clear, a spread of maturities is best, says Speight.
AMP’s Hassell also suggests if you want to get your yield up, buy highly rated credit securities – senior bank paper, Fonterra bonds, or energy company debt at senior level, which takes priority over more “junior” debt – provided the maturity isn’t too long. Or buy inflation-protected bonds that pay a real yield plus inflation.
He is in “protection mode” at the moment – protecting his portfolio from rising interest rates. Yet he doesn’t expect a sudden rush of interest-rate hikes in a world where there’s an overhang of too much debt in the system – US$50 trillion and counting, according to the Economist’s global debt clock.