Fixed interest: A primer on rate risk
Key Points
- Term deposits don’t have much exposure to interest rate movements
- Rules of thumb for estimating your risk
- Building your fixed interest portfolio
In fixed rate bond today is betting that floating rates will be lower over the next five years.
For bonds, which are traded, a bad bet is reflected in a lower price. Term deposits aren’t traded like bonds, so movements in interest rates aren’t reflected in the price – you just miss out on higher rates. Either way, small movements in rates won’t have much impact on your returns but big moves will. This is the risk you need to worry about.
You also should worry about holding long dated securities. Whether you hold a six month, or three year, term deposit doesn’t matter much. Buying a 20 year bond does.
Term deposits
If the fixed interest allocation in your portfolio is invested in six month term deposits to ‘avoid interest rate risk’, you’re choosing an expensive path.
You’re getting a lower return for a short term investment than a long one (multi-year term deposits include a reward for the certain funding you give the bank). Plus, by locking in for six months you’re assuming that interest rates will be higher when the deposit matures – a very precise bet. If they stay flat, or move lower, you’ll lose out.
Imagine you’ve got $100,000 to invest. Because you expect interest rates to rise in the medium term you put $50,000 in a two year term deposit paying 4.5% and the remaining $50,000 in a five year term deposit paying 5%.
After two years term deposit rates rise to 8% across the board, allowing you to reinvest the two year term deposit at the higher rate while the longer deposit earns the lower rate of 5% for the remaining three years.
The decision to fix the rate costs you $1,500 a year (3% multiplied by $50,000), or $4,500 in total. With a $100,000 portfolio that’s not much of a downside risk, especially when your overall income has risen.
Now let’s look at the strategy many investors use in practice. You invest $100,000 in six month term deposits, leaving you exposed to interest rates falling or staying flat in the short term. With a return of, say, 4% per annum, this strategy costs you $1,000 each year (compared to the five year term deposit) before any interest rate movements. If interest rates fell to 2% you’d be $3,000 short, which is 60% of your potential income at the outset.
For many investors, having their income stay put for a while as interest rates move up is a more tolerable risk than losing income as they fall.
Short term deposits and online savings accounts are a great place to keep your liquid funds (cash to take advantage of opportunities). But they save surprisingly little interest rate risk compared to longer term deposits and, if interest rates take a while to rise, you miss out.
Bonds, bond funds and ETFs
With bonds and ETFs, everything hinges on duration or term to maturity. A three year bond doesn’t carry much risk; a twenty year bond has plenty.
If you’ve invested $100,000 in a three year bond (or a portfolio of them), paying 5% per annum, you’ll earn $5,000 a year. The risk is that interest rates rise, causing the bond price to fall.
If interest rates rise to 8% after 12 months, your bond will be paying $3,000 less a year than a potential purchaser wants to earn – $6,000 over two years. So a buyer will need to be compensated by reducing the price by this amount (in practice, slightly less).liquidity to take advantage of opportunities – and great if you pick the future perfectly – building a fixed interest portfolio around short term deposits leaves you exposed to rates falling, without eliminating very much risk.
That’s a quick guide to working out how much interest rate risk you’re taking in the fixed interest portion of your portfolio. If you have questions, we’re only a Q&A submission away.
[1] The precise amount is just over $5,500 (ie the price would be about $94,500), since the future amounts need to be discounted to today’s dollars. But, for short-term bonds, adding up the income shortfall gives a pretty good (and conservative) approximation of the potential impact of rising interest rates.