What effect does rising interest rates have on your investment in bonds?
The Shadow Reserve Bank board member, Paul Bloxham, who is also HSBC’s Australian Chief Economist, was quoted in October as saying “What is becoming increasingly clear this month is that the Shadow Board thinks that the next move for interest rates is likely to be up and more likely than not it will be in the next six months.”
If Mr Bloxham is indeed correct, what effect does that have on your superannuation fund’s investment in bonds?
Well let’s begin with what are bonds? Bonds very simply represent debt obligation and therefore have similar characteristics to those of borrowings. So if your superannuation fund holds bonds then it is essentially lending money to Governments or Corporations to help them expand their operations. Corporations will typically issue bonds to fund the purchase of property or equipment in order to undertake business projects.
Just like a loan, the issuer, the Corporation or Government, pays the investor interest for allowing them to use their money. And just like a home loan, some bonds are issued with a fixed interest rate and some with a variable interest rate.
The fundamental principle of fixed interest bonds is that interest rates and bond prices generally move in opposite directions. That is (if as predicted above) interest rates rise, then the price for fixed-rate bonds will fall. For example, let’s say you have a corporate bond with an interest rate (referred to as the coupon rate) of say 2.5%. If interest rates were to rise to say 4% and you wanted to sell your investment it would be very difficult to source a buyer to pay you the same price you purchased the bond for. This is because new bond investors can now purchase bonds for the same price you paid but earn an interest rate (or coupon rate) of 4% rather than the 2.5% your bond would offer them. Consequently, the value of your investment must fall.
Conclusion
How would you feel if interest rates rose and you held fixed interest bonds in your superannuation fund. Please take time to review your bonds before interest rates rise not after they have risen.
Should you require any further assistance regarding bonds please feel free to contact Peter Quinn by submitting an online enquiry or calling us on +61 2 9580 9166 to book an obligation free appointment.
The information in this document does not take into account your personal objectives, financial situation or needs and so you should consider its appropriateness having regard to these factors before acting on it. It is important that your personal circumstances are taken into account before making any financial decision and it is recommended that you seek assistance from your financial adviser.
