Fixed interest securities make up part of most investor’s asset allocation. They’re considered low risk; second lowest after cash. But if interest rates continue to rise, should you continue to invest in them? We take a look.
What are fixed interest securities?
A fixed interest security is basically a loan from investors to a government or company. The issuer promises to pay back your capital at an agreed date, as well as a set amount of income each year (effectively interest on your loan, known as a coupon) until repayment. The rate of interest does not usually change over the life of the security. That means they’re usually a very predictable way of getting an income from your investment.
Securities issued by the government are called gilts. Those issued by companies are called corporate bonds. Gilts are generally considered less risky than corporate bonds since countries are generally more financially secure than individual companies. Both are generally less risky than shares: in the event that a company is liquidated, bondholders are repaid before shareholders. But, because they’re less risky, returns tend to be lower. And, as with all investments, there are no guarantees.
What’s the par value?
The amount that must be repaid to the bondholder is known as the par value (also known as the nominal, principal or face value). It is set when the bond is issued. However, it can change over the lifetime of the bond as it is bought and sold on the open market. Bonds are usually bought on the open market after it has been issued, where prices can vary from day to day.
If you hold a fixed interest security to the end of its term, you will get back the nominal value. But you don’t have to hold it for the whole term. You can buy and sell fixed interest securities on the stock market. Then, you’ll get back the market price, not the original nominal value. If the nominal value or market price you get back is higher than the amount you paid, you’ll make a profit.
The market price can fluctuate for a number of reasons including:
- General interest rate changes
- Changes to the credit rating of the issuer
- Changes to inflation
- The term left on the security (market value tends to be closer to the nominal value nearer the end of the term as there’s less risk of default).
The impact of interest rate changes
Prevailing interest rate movements can have a dramatic impact on fixed interest securities. Since their interest rates are fixed, they become less valuable in real terms as general interest rates rise.
In short, bond yields tend to rise in response to interest rate rises, but their prices fall.
You can take our word for it and skip down the page, or if you’d like to try and get your head around the reasoning, take a look at the following example.
To appreciate the impact of interest rate changes on the value of fixed interest securities, we need to understand the relationship between bond yield and bond price.
A bond yield is the amount of return an investor realises on a bond. As bond prices increase, bond yields fall. Here’s a simplified example to try and explain:
John buys a bond with a 10% annual return and a par value of £1,000. So the annual interest is £100. Its yield is the interest divided by its par value. In this case then, the nominal yield is 10% (the same as the coupon rate).
John decides to sell the bond for £900 to Jill. Jill receives an interest rate based on the face value of the bond - £100 per year. But she only paid £900 for the bond, so the rate of return is 11.1%. So the price fell, but the yield increased. Got it?
The price of a fixed-rate bond changes in response to changes to general interest rates. This is because the issuer has promised to pay a coupon value (interest) based on the original par value of the bond. Let’s say that starts at the same rate as prevailing interest rates. We’ll stick with our example value of 10%. Both corporate bonds and government bonds would return £100 on our £1,000 par value.
BUT, if prevailing interest rates drop to 5%, the investor can now only get £50 from the government bond, but would still receive £100 from the corporate bond, making the corporate bond much more attractive. That means investors will bid up the price of the corporate bond until it equalizes the prevailing interest rate. So here, the bond will trade at a price of £2,000 so that the £100 coupon represents 5%.
Last month saw the first interest rate rise in over a decade in the UK. During the preceding period of sustained low interest rates, investors had struggled to find decent returns from cash deposits, causing many to turn to bonds. If rates were to rise significantly from current low levels then these investors could face capital losses on their investment.
There are other risks linked to interest rate rises – including a spike in inflation or a rise in geopolitical risk – that would have a similar effect.
So should you continue to invest in fixed interest securities?
If interest rates rise faster than expected, returns on fixed interest securities could be hit hard. But that is a big if. We have no idea how quickly interest rates will rise. So don’t panic.
Whilst interest rate rises pose a threat to all bond investors, not all funds are created equal. Some are better places to weather any hikes. Shorter duration bonds (where duration here is a measure of how sensitive the bond is to changes in interest rates) could be a good move. So too could high-yield or inflation-linked bonds. The difficulty then is that everyone will have had the same idea, so prices will be high.
Fixed income securities have traditionally played an important role in portfolio diversification. Given their low risk profile, they can provide a safe haven from market turbulence. They can also be a good way to generate a regular income stream. But picking the right kinds of bonds will become more important.
Bond funds, where you’re investing in bonds from a mix of issuers, could be a good choice as they help spread your risk. They often also give greater freedom to switch between different types of credit, depending on the economic backdrop. They can’t promise a fixed return as all the bonds within the fund have different interest rates and maturity dates. Instead, they aim for a target return.
Overall, the expectation is that interest rate rises will be gradual and moderate. So there should still be the opportunity for moderate returns from the fixed interest market as part of a diversified portfolio. Initial volatility following rate hikes could even present buying opportunities. But getting expert help is a good idea. And we will need to keep an eye on how things progress.
Please note, throughout this article references to gilts are in relation to the UK government. Gilts from other countries may carry significantly more risk.