Welcome to the world of bond investing. Whether you're a seasoned investor seeking to deepen your understanding or a first timer, we'll help you understand how bonds function and the important role they play in investment portfolios.

Interest rate cycles

Interest rates have an enormous effect on investment markets as they fluctuate in the short term but follow very long-term cycles. The most recent full interest rate cycle started after World War II when interest rates were low. Rates rose slowly through the 50s and 60s and then accelerated through the 70s and 80s, before declining all the way until rates bottomed in late 2021 before rising steeply through 2022. This turn in interest rates appears to have started a new long-term cycle.

After decades of steady returns for bond investors, 2022 saw quite substantial losses. Unfortunately, this was paired with losses in local and global stock markets, making 2022 one of the worst on record for the typical ‘Balanced’ investor, where virtually all asset values fell.

Overall, 2023 was a better year for investors, but the sour taste of losses can linger and sent many investors on a flight for safety in savings accounts and term deposits. However, this can lead to long-term investor underperformance, as cash and term deposits rarely outperform inflation and provide little ‘real’ return.

How bonds work

Bonds are debt securities that represent loans made by investors to entities, such as governments or corporations, in exchange for regular interest payments and the return of the principal amount at maturity.

When an investor purchases a bond, they are essentially lending money to the issuer. In return, the issuer promises to pay periodic interest, known as the coupon, and return the principal when the bond matures. Bonds come with different maturities, ranging from short-term (less than one year) to long-term (typically 10 years or more).

Interest rates and bond prices

The relationship between interest rates and bond prices is fundamental to understanding bond market dynamics. As interest rates in the broader economy fluctuate, the prices of existing bonds experience changes. The key principle is that when interest rates rise, the value of existing bonds tends to fall, and vice versa.

The reasoning behind this inverse relationship is rooted in the fixed nature of bond coupon payments. The coupon rate is the fixed interest rate that a bond pays based on its face value. When interest rates in the market fall below a bond's coupon rate, the bond becomes more attractive to investors seeking higher yields, and the price of the bond rises.

When interest rates rise above the bond's coupon rate, newly issued bonds offer higher yields, making existing bonds with lower yields less desirable. As a result, the prices of these existing bonds fall, creating a discount to their face value.

Practical implications for investors

Understanding the impact of interest rate changes on bond prices is crucial for investors to make informed decisions. While bonds can provide stability and income, it's essential to be mindful of the potential price fluctuations in response to interest rate movements.

When exploring investment bonds, investors should consider the following strategies:

1. Diversification

Holding a diversified portfolio of investment bonds with varying maturities and issuers can help mitigate the impact of interest rate changes on overall bond holdings.

2. Monitoring economic indicators

Keep an eye on economic indicators and central bank announcements, as these can provide insights into potential changes in interest rates.

3. Professional financial advice

Consult with a Findex financial advisor who can help tailor a portfolio to your individual risk tolerance, investment goals, and market conditions, including the right allocation to investment bonds for your circumstances.

Globally, there is the expectation that interest rates will start to fall in 2024. This means that rates of return from savings accounts and term deposits will adjust down immediately. However, from what we’ve noted above, falling interest rates is good for bond investors who have a coupon rate locked in and the potential for capital appreciation on their bonds as interest rates fall.

Now is a great time to reassess your current investment strategy and prepare for what is ahead of us and not what’s in the rear-view mirror. Stay ahead of the curve by gaining insights into the latest market trends, activities, and analyses in our NZ Investment Outlook Webinar.

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