Trying to Satisfy Investors Thirst for Yield

Bank deposits are returning practically nothing unless investors are prepared to lock away money for several years.  Property values continue to fall, and many fear the continued volatility in share markets.  Where can investors get a decent yield? For a number of weeks we have had queries from investors looking for a decent yield on their investment but unwilling to invest in shares.  They have been asking “What about bonds?”

 
Bond returns look attractive relative to bank returns, but are they a safe bet? Bonds are issued by governments, local authorities, and companies to raise cash to finance projects and activities.  When you buy a bond, you are effectively lending money to the issuer, for an agreed timeframe and interest rate.  The interest rate is known as the coupon rate.  Typically interest is paid quarterly or every six months, and the initial investment is repaid when the bond matures. 

In order to attract investors, bond issuers typically offer interest rates above bank rates.  This is no different to how finance companies used to set their rates several years ago.  With bank rates in NZ at historic lows, bonds are very much in the thoughts of investors looking for yield.  They may also mistakenly believe that the yield will come with good security.

Bonds are often publicly listed so there is in theory a secondary market for those wanting to sell out before maturity and for those who want to invest.  Once bonds are issued, they can be traded on the market just like shares.  If you decide to sell a bond on the market before maturity date, there is no guarantee it will be worth what you paid for it.  Just like shares, bonds fluctuate in value, in response to demand.  The demand for bonds is invariably driven by what’s going on with interest rates at the banks.  If interest rates at the bank increase, the price people are prepared to pay for bonds already on issue invariably falls.  Also if the issuer runs into financial difficulty the bond will drop in price as people will demand a higher yield for the extra risk they are taking on. 

To illustrate this, let’s take a simple example.  Say you buy $10,000 of a new bond issued by a local corporate paying an 8.75% coupon and so returns $875 per annum in interest payments.  If market interest rates decreased, investors would be willing to pay you more than $10,000 to buy an income stream of $875 per year.  For example, if market interest rates went down to 7%, in order to get a 7% return someone would be willing to pay you $12,500 for your $10,000 of bonds (because the $875 of income divided by $12,500 = 7%).  In this example that would give a 25% capital gain.  But if you purchased the bond on the secondary market for $12,500 at a 7% yield, and the market interest rate returned back to 8.75%, you would have a 20% capital loss.

The gains or losses using the above example show equity (share) like volatility.  A similar cash flow return could be generated through an investment in high dividend yielding shares.  The subtle difference is that people invest in shares expecting that the share price will vary.  A real concern for investors new to investing in bonds is that they may not be fully aware of the changes in capital values of the investment that occur when prevailing interest rates change.

Over the course of the past year, we have seen probably the greatest fall in New Zealand short term fixed interest rates.  In the mid1980’s we saw the exact opposite when interest rates rocketed.  This was in the days before the current Official Cash Rate mechanism was introduced by the Reserve Bank.  We need to remember that if inflation takes hold, the Reserve Bank will undoubtedly increase the OCR.  Invariably prevailing longer term interest rates will also move.  This could result in significant capital losses for those who have invested in recent bond issues who need to sell prior to the bond maturing.