INSIGHTS

The role of fixed income in a portfolio

The role of fixed income in a balanced portfolio is to provide a regular and known income stream, the repayment of capital at maturity (assuming no defaults), along with helping to reduce the volatility of the entire portfolio.

However, many investors will have noticed that the current market value of their bond portfolio has declined over recent months and maybe wondering “why has the price of my bonds fallen when there has been no change to the regular coupons received and clearly no default by the issuer?”

In short, the fall in value is due to the sharp upwards move that we have seen in interest rates over recent months. Bond prices and interest rates are inversely related - so, when interest rates fall, the price of a bond will rise, and when interest rates rise, the price of a bond will fall.

The reason for this is simple. Since coupons on a bond are fixed, if interest rates move, the price of the bond needs to adjust so that the effective yield (or return) on the bond is commensurate with the prevailing interest rate. For example, why would you buy a bond trading on a 3% yield when you could get a 5% return on another bond with the same maturity date and risk profile.

The purchase yield is the return you receive if the bond is held to maturity

What is important to the holder of a bond, is the yield at the time the bond was purchased. This is the return the holder of the bond will receive if the bond is held to maturity.

While the upward movement in interest rates means the returns you are receiving on some current holdings are lower than what you could get if you were making the purchases today, the income stream has not been impacted.

If you hold the bonds until maturity, you will receive the same interest payments and the principal back. However, if you sell a bond, then you may not get all the principal back in the event interest rates have risen.

The purchase yield is often forgotten as prices and portfolio values fluctuate. What investors need to remember is that any gain or loss in a bonds value due to market movements is not permanent. This is because the price of a bond will always converge towards its face value as it nears maturity.

For example, say you purchase a 5-year bond with an annual coupon (interest rate) of 3% and a face value of $100. At the time of purchase, you know you will receive a fixed coupon or payment of $3 per annum ($100 x 3%) for 5 years, and on maturity you will also receive your $100 of capital (face value) back.

If, after one year of holding the bond, interest rates rise to 5% the price of the bond would decline to $92.91 so that the effective yield on the bond is equivalent to 5%. While you would have collected the $3 annual coupon, the price of the bond would show a decline of 7.1% in your portfolio.

However, if you hold the bond through to maturity, you will still collect the original $100 invested (the face value of the bond) and all of the cash flows paid over the life of the bond (see chart below). This would equate to a 3% pa return, which was the yield when you purchased the bond.

For someone purchasing the bond on market in year one for $92.91, they would receive four years of cash flows ($3 x 4 = $12) plus the $100 face value on maturity. This equates to a 5% return on their purchase price of $92.91.

The price of a vanilla bond converges to its face value at maturity

If only I had…

While hindsight is great, and you may occasionally catch yourself saying, “if only I had bought sooner” or “if only I had waited a bit longer to buy”, when it comes to investing, trying to time markets and predict the best time to buy, or sell is a very difficult task. Markets can turn quickly, and not being invested during these periods can negatively impact the overall return of your portfolio.

Making prudent decisions based on current risks and the broader economic outlook to ensure your portfolio is positioned to weather fluctuations in the broader market is the best strategy you can adopt. This has been proven time and again.