GALLEON INSIGHTS

Fixed Income Securities

Fixed Income Securities

Historically, fixed-income securities have been a safe haven for investors looking to limit the risk associated with the stock market. Despite there are some risks in loosing money, you can invest in various durations of bonds knowing that there are high odds of making money.

That is until 2022 came around!

2022 could be one of the worst year in history for bonds. Bond values have dropped significantly during the year ending 31 December 2022. And if you added fixed income securities for the purpose of diversifying your portfolio, it would have got backfired . Ouch…..

Bonds:

A bond refers to a financial instrument where an investor lends money to a borrower for a specified duration, with the borrower making regular interest payments. The period between the bond issuance and the borrower’s repayment date is known as the “term to maturity.” Bonds come in two main types, namely government bonds, where the borrower is the government, and corporate bonds, where the borrower is a business or a bank. The key distinction between a bond and a typical loan is that, after issuance, a bond can be bought and sold by investors on a financial market, which means that it has a market value

Bond Prices vs Yield:

Bond prices and yield have an inverse relationship. When bond prices rise, the yield falls, and vice versa . So how do bond prices and yields work in the real life ?
A bond typically might have a face value of $1,000, an interest rate or coupon, and a maturity date. For instance, if you purchase a bond with a 2% interest rate that matures in ten years, you pay $1,000 initially. Over the next ten years, you receive 2% interest on your $1,000 investment twice a year. When the bond matures after ten years, you receive your $1,000 investment back in addition to the interest earned. – Pretty straight forward ?

The process of buying and selling bonds on the secondary market can be perplexing. The bond’s face value changes due to supply and demand. For example, if an investor owns a ten-year bond with a 2% interest rate, and the Federal Reserve increases interest rates, new ten-year bonds may have a 4% interest rate. As an investor, you would prefer the bond with the higher interest rate. As a result, the owner of the 2% bond may sell it for less than its face value. The buyer, if they hold the bond until maturity, will receive 4% interest, plus the difference between their purchase price and the bond’s $1,000 face value. In theory, this combined amount should be around 4%, the new going rate for bonds. On the other hand, a 4% bond could sell for more than face value if interest rates are significantly lower.

Inflation – So how does inflation come into the party ?
In Australia, inflation remained between 1% to 2% from 2015 to 2021. However, in June 2021, it surged to above 3%. As we know, inflation also increased considerably in other parts of the world, including Europe. In Spain, inflation was at 10%, in Germany at 7.6%, in France at 4.5%, and in the United Kingdom at 6.2%. The overall inflation rate for the Eurozone rose to 7.5% in March 2022

Some of the factors that caused inflation were :
• Relaxed fiscal and monetary policies during pandemic : Massive amounts of stimulus were pumped into economies.
• War in Ukraine
• Increased energy prices
• Supply chain issues
• Low unemployment
• Issues with globalization due to Covid pandemic

Sudden jump in inflation took most Central banks by surprise ( Ye.. Ask RBA…) and monitory policy tightening was inevitable.

Monetary policy influences bond yields heavily. Generally speaking long-term interest rate expectations are very sensitive to changes in inflation or economic growth expectations. In controlling the runaway inflation, on 16 March 2022, the US Federal Reserve raised interest rates for first time since December 2018. They raised them by 0.25% and signaled there will be six more during the year.

And Jerome Powel didn’t lie !

As you would expect during 2022 bond yields jumped over the roof and bond prices took a massive hit.

Diversification – Why investing in Fixed income securities

Historically, fixed-income securities have exhibited less risk and volatility as they represent debt instruments. Investors can assess the financial health of the company or nation that issued the bond and calculate their returns based on the stated interest rate. Moreover, as a debt holder, you are a priority claimant should the company go bankrupt. Although there is no guarantee that you will recover your investment, the likelihood of doing so is relatively high.

In contrast, investing in stocks carries significantly higher risk, and to mitigate this risk, investors allocate a portion of their funds to bonds.

Despite experiencing a challenging year, bonds continue to be a vital asset class to be included in a portfolio based on your risk preference. In times of economic uncertainty, long-term bonds become more attractive to investors as they provide a guaranteed return over the long haul. This results in an inverted yield curve, where short-term bonds offer higher yields than long-term bonds. Moreover, during such periods, investors tend to shy away from the stock market due to uncertain returns or lower-than-expected returns. Instead, they opt for bonds as they offer a predictable return with minimal risk to the principal amount. Therefore if you are a long term investor bonds still have its place in a diversified portfolio.

Given high yields, another option available is having short term bonds( or T-Bills ) . For example 3months – 2 year Bills. Short term instruments are less sensitive to price movements. For example, you might purchase a three-month bill that matures in one month, essentially making it a one-month bill with a guaranteed return.

Including bonds in an investor’s portfolio is generally considered as a wise decision because it provides a stable long-term return while lowering the risks and volatility. Although 2022 has been historically challenging for the bond market, it’s crucial to maintain a realistic perspective. Considering historical numbers, bond market won’t always perform poorly. As central banks continue to manage inflation, there should be some stabilization in the bond market. Even if inflation remains high for an extended period, as long as the monetary policy has it under control, there is a possibility that things will eventually settle down.

BY : Shan Muthukuda | Galleon Capital & Advisory Pty Ltd
Galleon Capital & Advisory Pty Ltd (Corporate Authorised Representative No. 001301679) and Shan Muthukuda (Authorised Representative No. 001233173) are authorised representatives of Spark Advisors Australia Pty Ltd ABN 34 122 486 935 AFSL 380552

General Advice Warning: “The information in this document has been prepared for general information purposes only and does not take into account your personal objectives, financial situation or needs. It is not intended to provide commercial, financial, investment, accounting, tax or legal advice. You should, before you make any decision regarding any information, strategies, or products mentioned in this document] consult a professional financial advisor to consider whether it is suitable and appropriate for you and your personal needs and circumstances. Before making a decision to acquire a financial product, you should obtain and read the Product Disclosure Statement (PDS) relating to that product, together with the Target Market Determination (TMD)”.

 

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