Menu Close

Fisher Investments UK on the current state of fixed interest

view original post

The 2022 downturn in these instruments has revealed that many investors don’t fully understand how fixed interest works, what factors affect prices or whether to change their exposure to these assets.

Fisher Investments UK can help. In this article, we’ll explain what you need to know about fixed-interest investments and why their performance has suffered in the current environment.

What exactly are you investing in when you invest in fixed interest?

To better understand fixed interest in the current environment, Fisher Investments UK believes it’s best to start with the basics. The term “fixed interest” is somewhat interchangeable with “debt”. Investors typically purchase fixed interest to generate a predictable income stream and to protect against short-term price volatility in other asset classes, such as equities.

When you buy a fixed-interest security, you’re essentially lending money to an entity – often a government agency or corporation. Investors purchase the debt in return for regular interest payments (sometimes referred to as “coupons”). As with most types of debt, borrowers must repay what they’ve borrowed. So, investors also expect a return of their money at a pre-specified maturity date.

Much like equities, fixed-interest securities are priced in an auction market. Investors bid on fixed-interest securities, which helps determine the interest rate an entity will need to pay investors. The higher the demand, the lower the interest rate, and vice versa. In Fisher Investments UK’s view, two other key elements affect the interest rate:

  • Maturity dates: how far into the future the fixed-interest security matures. In many circumstances, longer maturities carry higher interest rates than shorter maturities.
  • Creditworthiness of the issuer: investors require higher interest payments from issuers at greater risk of default (such as failing to make an interest payment). For example, Turkey – currently facing a currency crisis – must compensate investors for taking on additional risk by paying higher interest rates on their debt than the US government pays.

How does pricing for fixed-interest securities work?

Governments or corporations issue debt on a primary market – where investors purchase a set number of securities directly from the issuer. Fixed-interest securities start with the same price – usually a multiple of 1,000, depending on the base currency – known as the par value of the security. So, for fixed interest, the auction dictates the interest rate rather than the price (like with equities).

After the initial auction, fixed-interest securities trade on a secondary market – where investors can buy and sell fixed-interest and other types of securities with each other. Once on the secondary market, fixed-interest security prices have an inverse relationship with market interest rates – the rate investors would demand if a similar company were to issue debt with similar terms. When market interest rates go up, prices for previously issued fixed interest (trading on a secondary market) tend to go down. When market interest rates go down, prices go up. Why is that the case?

Imagine you’ve purchased a fixed-interest security that pays 1pc annually. For your €1,000 investment, you’ll receive €10 per year until maturity. Now imagine that a similar company with similar risks issues newer debt, but the market interest rate has increased to 2pc. Your fixed-interest security is now worth less because an equivalent security now pays €20 per year. To sell your lower-paying security on the secondary market, you would now need to offer a lower price. This works the other way around too. Using the same example, if a similar company issues comparable debt and market interest rates have fallen to 0.5pc, your security is now more valuable.

What else can affect fixed-interest pricing?

Another variable that can affect fixed interest pricing is credit spreads. Credit spreads measure the additional amount of interest an entity would have to pay relative to “safer” options. An example of a common credit spread is comparing a corporate interest rate to a government’s interest rate.

Imagine a heavily indebted company that has to issue more debt to keep operating. Now compare that to a very stable entity, such as the US government, which issues new debt regularly. The indebted company would have to pay more interest than the US government to compensate investors for the higher risk of default. The difference between the two interest rates is the credit spread.

Normally, credit spreads don’t often fluctuate dramatically. However, spreads can widen significantly in times of economic weakness. When spreads widen, fixed-interest prices fall because the market is factoring in additional risk. And when they narrow, prices rise – all else equal.

What’s happening to fixed interest this year?

Fisher Investments UK believes understanding how fixed-interest prices work is critical to understanding why fixed-interest investments have done so poorly this year. Figure 1 shows 2022’s global fixed-interest return so far, compared to historical annual returns.

Global fixed-interest securities have suffered as market interest rates have quickly risen across the world. The relationship is far from perfect, but interest rates and inflation generally move in the same direction. The Covid-19 crisis created supply-chain challenges that have taken longer to resolve than most anticipated, partially due to China’s zero-Covid policies. Combined with spiking commodity prices surrounding the tragic Ukraine/Russia war, inflation has remained high. Since inflation is higher, interest rates have risen – a negative for fixed-interest prices.

Figure 1: Global fixed interest returns thus far in 2022 are at their lowest in decades

Source: Global Financial Data (GFD), as of 7/5/2022. GFD Indices World Government Bond Equity Market-Cap-weighted Return Index, Annual Total Returns, 1900 – 2021. Past performance is not a reliable indicator of future returns. *Year-to-date figure, 1/1/2022-30/6/2022

Credit spreads have also widened, causing further losses in certain fixed-interest securities. There are a myriad of fears investors are digesting (including inflation, recession risk and war) this year, which has caused a “flight to safety”, where investors prefer government debt to corporate debt. Figure 2 illustrates the difference in total return between these two categories of debt.

Figure 2: Corporate debt has underperformed government debt this year

Source: Factset. ICE BofA Global Corporate & Government Total Return Bond Indices from 31/12/2021 to 4/7/2022. Past performance is not a reliable indicator of future returns

What should you do with your fixed-interest investments?

While the downturn in fixed interest has been difficult this year, we don’t think investors should panic. Fisher Investments UK believes a portfolio’s asset allocation – the mix of equities, fixed interest, cash and other investments – has the biggest influence on an investor’s long-term returns. Investors should tailor portfolios to meet their long-term goals and cash flow needs while considering the length of time these assets need to last.

Equities tend to have the highest long-term return potential, but can be volatile in the short term. For example, equity declines have exceeded fixed interest’s drop this year.

Deviating from your long-term asset allocation based on short-term market wiggles can potentially derail a sound long-term plan. Fixed interest can still play an important role for investors who need or want to experience less equity market volatility in the short run. Fisher Investments UK suggests conducting regular reviews to ensure your portfolio’s asset allocation continues to make sense for your long-term goals. Unless your circumstances have changed materially, your allocation likely shouldn’t change either.

Interested in other topics by Fisher Investments UK? Get our ongoing insights, starting with a copy of Markets Commentary.

Follow the latest market news and updates from Fisher Investments UK:

• Facebook
• Twitter
• LinkedIn

Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. This document constitutes the general views of Fisher Investments UK and should not be regarded as personalised investment or tax advice or a reflection of client performance. No assurances are made that Fisher Investments UK will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. Nothing herein is intended to be a recommendation or forecast of market conditions. Rather, it is intended to illustrate a point. Current and future markets may differ significantly from those illustrated here. In addition, no assurances are made regarding the accuracy of any assumptions made in any illustrations herein. Fisher Investments Europe Limited, trading as Fisher Investments UK, is authorised and regulated by the UK Financial Conduct Authority (FCA Number 191609) and is registered in England (Company Number 3850593). Fisher Investments Europe Limited has its registered office at: Level 18, One Canada Square, Canary Wharf, London, E14 5AX, United Kingdom. Investment management services are provided by Fisher Investments UK’s parent company, Fisher Asset Management, LLC, trading as Fisher Investments, which is established in the US and regulated by the US Securities and Exchange Commission.

Investment management services are provided by Fisher Investments UK’s parent company, Fisher Asset Management, LLC, trading as Fisher Investments, which is established in the US and regulated by the US Securities and Exchange Commission. Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.