APRA News Article for October 2010 edition
With investment markets uncertain, many investors have sought the fixed interest markets as a safe haven. While term deposits and cash management trusts can generally be considered safe, particularly with the current Government bank guarantee, this article examines fixed interest investments that are often held in managed funds and allocated pension/superannuation funds that could actually lose money in a rising interest rate environment.
The fixed interest funds we are referring to here are usually called “Fixed Interest” or “Capital Stable” funds and form part of the investment menu of managed funds, allocated pension funds and superannuation funds.
But how can it be that a fixed interest fund can lose value? The underlying investments of a fixed interest fund typically include long dated Government Bonds. In Australia the Government currently issues 10 year bonds. If an investor purchased a Government Bond and held it until it matured in 10 years time, then the investor would receive their capital back at maturity assuming that the Government was not insolvent. So far, so good.
Fixed Interest funds usually (or should) price their investments daily and it is with this point in mind, that investors in these funds can lose value in a rising interest rate environment. To highlight this point, consider an investor who purchased a 10 year bond for $100,000 with an interest rate of 5%. The investor receives $5,000 of interest each year. Should interest rates move up to 10%, the investor would only require $50,000 of capital to generate the same level of income. When fixed interest investments are valued daily, it is this logic that is used to determine the current value of a bond. The principle is simple, fixed interest investments can increase in value when interest rates fall, and can lose value when interest rates rise.
Information sourced from Eurostat, International Monetary Fund and Bloomberg show that forecast annual Government Budget deficits around the world for 2010 – 2012 will be around USD $8 trillion (assuming budget balances are converted into US Dollars using the exchange rate on 12th May 2010). The IMF has forecast in its Economic Outlook in April 2010 that these deficits are to be financed by a limited pool of savings. The IMF forecast that the combined global current account surplus positions for 2010 – 2012 are around USD $3.8 trillion. This means that it is forecast that governments around the world will require $8 trillion of funding over the next 3 years, but the savings pool is forecast to be less than half that.
This can only result in competition for debt from Governments around the world and the simple forces of supply and demand tells us that this can only lead to increases in interest rates.
Linking back to the effect of rising interest rates on fixed interest investments, below is a chart prepared by Magellan Financial Group showing the loss of value of Government Bonds assuming a rise in long term interest rates of 2% and then by 4%. You will see that the value of an Australian 10 Year Government Bond would drop by 24.9% in the event of long interest rates rising by 4% (light blue bar), and would fall in value by 13.6% if long term rates increased by 2% (mid blue bar).
The message here is clear, Government debt around the world exceeds available savings and is extremely likely to put upward pressure on long term interest rates. Investors should assess the impact of rising long term interest rates on any fixed interest investments they hold as a matter of urgency.
Author of this article is Mark Draper, from GEM Capital Financial Advice. Further investment knowledge is available on the GEM Capital website – staging.gemcapital.com.au.
For those wanting to complete presentation from Magellan Financial Group about the issue of rising long term interest rates, please either ring (08) 8273 3222 or email your request to