How fixed interest works
In this video we explore how changes in interest rates can impact fixed interest returns. Globally, interest rates are at historically low levels. This is likely to change in coming years as the global economy improves. This means fixed interest returns aren’t likely to be as high as they have been in previous years. We show examples of the effect different interest rate scenarios can have on bond prices and returns and look at strategies to manage interest rate risk.
Information provided in this video current as at October 2013. This material is of a general nature and does not take into account your personal objectives, situation or needs. Before making a decision about AustralianSuper, consider your financial requirements and read our Product Disclosure Statement (PDS), available at www.australiansuper.com or by calling 1300 300 273. Investment returns are not guaranteed as all investments carry some risk. Past performance gives no indication of future returns.
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Interest rates are one of the main things that impact fixed interest returns. Funnily enough, when interest rates go down, fixed interest returns usually go up and vice versa. Interest rates around the world have been falling since the Global Financial Crisis. In Australia, the cash rate is now at its lowest level on record. This rate is important because it impacts other interest rates like those on home loans and fixed interest securities like bonds....
Different countries have different levels of interest rates, depending on the strength of their economies. For example, interest rates in the United States are lower than in Australia. In fact, they've been close to zero since December, 2008. Yet fixed interest returns have been very high since the GFC. Here, we can pay the returns of global fixed interest which includes Australian and international fixed interest and Australian shares over two 5-year periods.
Shares tend to perform better when the economy is performing well like in the five years leading up to the GFC. Fixed interest usually performs well when the economic outlook is not so good and interest rates are going down, which is exactly what happened following the GFC.
Fixed interest returns aren't always fixed. The return is only fixed if you hold the bond until the end of its term. In this case, your return is the same as the bond's interest rate. While for most bonds, the interest rate is fixed for the life of the security, prices change every day in the bond market. This is where fund managers, brokers, and other investors buy and sell bonds. Bond prices reflect the outlook for the economy and interest rates.
Super funds like AustralianSuper value their fixed interest securities everyday based on interest rates and prices in the bond market. We use these values to work out investment returns. Typically, bond prices and interest rates move in opposite directions. When interest rates go down, bond prices go up. When interest rates go up, bond prices go down.
Jane paid $100 for a bond with an interest rate of 3%. It has four years left until it matures. If interest rates stay at 3%, Jane's bond will still be worth $100 in four years' time so her return won't change if she sells it now. But if interest rates change in the future and Jane decides to sell her bond, her return will change.
Let's see what happens if interest rates fall to 1%. Jane's bond would be worth more as it's paying a higher interest rate than new bonds. Remember, Jane's bond has an interest rate of 3% while new bonds have an interest rate of 1%. The price of Jane's bond has now increased from $100 to around $108. This means her return will go up.
What happens to Jane's bond if interest rates go up by 2%? Jane can either hang on to her bond and get paid 3% interest per year or she could sell it. If interest rates rise by 2%, Jane's bond would now be worth less as investors can get a better interest rate from new bonds. So the price on Jane's bond will fall. She would get around $92 if she sold it instead of the $100 she paid for it. So her return would go down.
Well, interest rates are at very low levels and can’t go much lower. As global economic conditions improve, interest rates are likely to rise. This means fixed interest returns are unlikely to be as high as they've been in previous years. While fixed interest returns can fall over shorter time periods, they don't fall as much or as often as shares. In fact, over the longer term, returns tend to reflect the average interest rate of the securities held in a portfolio.
AustralianSuper tries to minimize the negative impact changing interest rates can have on portfolio returns. One of the ways we do this is by actively managing the types of securities in the portfolio. Fixed interest is only one part of a diversified investment strategy. Combining different asset classes like fixed interest, shares, infrastructure, and property can reduce fluctuations in returns.
If you have any questions about investing your Super, call us and ask to speak to a Super adviser.