Explainer: Fixed interest, what is it and how does it work?

We are following other recent articles in this series to break down financial jargon and explain a part of investing that can be counter-intuitive: fixed interest. It is often presented in a complicated manner and is considered the less exciting component of a portfolio, relative to shares. This article is all about making sense of the asset class or type of investment that is called fixed interest.

Like many investments, there are several words that mean the same thing. The term fixed interest is often used interchangeably with bonds. You can have government bonds and corporate bonds.

A bond is basically a loan from the investor to the institution that issues the bond, i.e., the government or company. They are called the issuer. It is called fixed interest because this loan is at a set and fixed interest rate.

For example, a government might issue a bond that looks like this:

• issue price €100 (this is called the face value),

• interest rate 2%pa (the interest rate is called the coupon rate, because why not add more unnecessary jargon),

• duration 10 years (duration is more self-explanatory, it is how long the bond lasts until it completes. This is sometimes referred to as maturity).

This means that if you invest €100 you will receive a return of 2% per annum, and at the end of that time, you will get your €100 back.

The rate of interest at which a bond is issued is determined by many things.

One is risk. We have written before about the relationship between risk and return. If an investment is considered a higher risk, an investor will expect a higher return. When it comes to fixed interest (bonds), the risks are that the issuer may miss a payment, or that they may not pay back the original amount. This is called defaulting on the bond. A higher risk will demand a higher return.

Bond issuers considered very low risk, eg governments of the USA, Germany and the UK, can issue bonds at a lower interest rate. Some large companies can fall into this lower risk end of the spectrum, like Apple and Microsoft. There are bond ratings agencies and a scale of bond risk profiles, but we will leave that for a separate discussion.

A second is the official interest rates set by central banks, and a third is the dynamic between demand for bonds and supply of bonds.

The official interest rate is of more relevance for investors, so we will focus on that.

So, it all seems quite straightforward, you invest in a bond, you receive a predictable return and receive your capital back at the end. However, it does get a bit more dynamic, and this is where it really impacts your portfolio.

We know that bonds are considered relatively lower risk than shares as an asset class which translates as lower risk and volatility, and lower but more predictable returns. Lower risk and volatility does not mean none though. For those people that are interested in bonds, the last 18 months has been an abnormally exciting and potentially negative time for bonds. This is because of interest rates.

Somewhat counterintuitively, the returns one achieves when investing in bonds, is inversely related – it moves in the opposite direction – to changes in interest rates. When interest rates are falling, bond returns tend to go up, and when interest rates are rising, bond returns fall.

If you buy and hold a bond to maturity, your return is not so impacted, because you receive the fixed interest rate and your original investment back. But, and this is where interest rates become impactful, bonds have a value relative to current interest rates, because they can be bought and sold. An investor can sell a 10 year bond they bought 2 years ago and that has 8 years of income left to receive, and buy a new bond. If interest rates are going up, then new bonds being issues will be at a higher interest rate than the one the investor bought two years ago, and its value will have fallen. If the investor wants to sell it they will have to sell it at a discount. When interest rates are falling, that bond you bought two years ago might be at a higher interest rate than new bonds being issued. If you sell it, you can ask a premium above its original value. This buying and selling of bonds takes place in what is called the secondary market and is where excess return can be achieved. The price of a bond is ultimately mean reverting. By this we mean a bond with a face value of €100 will move back towards this value as it gets closer to its end date.

There are a number of other layers and decisions such as duration. Should the investor buy a 10-year bond, or should they go for 1,3,5, 20 or 30 years? Across market cycles some time frames are more attractive than others.

In a professionally managed portfolio, many decisions are being made constantly about what type of bond to hold, for how long, whether to continue to hold, or to sell and buy a different one.

In the last 18 months, this sector has been more volatile that the share market and a view of US government 10 years bond yields (the issued interest rates) over the past 25 years helps to explain this:

It is very clear that from late 2020 to the end of quarter 3, 2023 official interest rates rose sharply, and in response, bonds were issued at increasingly higher interest rates. This positive spike in the graph is actually reflective of a negative return in the fixed interest sector. As central banks move towards the end of their rate rising cycle, so this trend will revert and we expect to see this across the next 12-18 months.

For anyone that has taken a lower risk approach to the portfolio and is looking to understand the volatility they have experienced in the last two years, we hope this article provides some clarity. We are also available and happy to meet with you and go into more detail into the specifics of your holdings and your situation. Contact us at info@blackswancapital.eu.