By Craig Simpson
If the rhetoric coming from the Bank of England (BoE) and US Federal Reserve (Fed) is to be believed we could see higher interest rates by the end of the year and with it a greater level of volatility in sectors such as fixed income (bonds).
Any upward move in interest rates globally will invaribly have a negative impact on the Default and Conservative KiwiSaver funds with their considerable exposure to fixed income assets.
Many investors think bonds are low-risk and are:
1) substantially less volatile than equities and
2) uncorrelated with equities.
These beliefs could be about to be found wanting if events play out as some commentators are suggesting.
Recent market events (Greece and China) are biting into portfolio returns and we note some KiwiSaver funds are recording negative unit price movements over the past one to three months. Not all of the negative moves are linked to the more aggressive, equity heavy funds either.
More conservatively managed funds are also taking a hit which will surprise savers who believe they are in low risk strategies with minimal chances of loss.
The last quarter has taken a little bit off the top from the longer run returns and at this stage this has not has too much of an adverse impact on the overall balance of our regular saver who we model our analysis around.
Some of the drivers behind the drop in performance will be due to a range of factors which include:
- a spike in US and European bond yields which drives capital values lower (see below);
- the sharp decline in the NZD versus it's major trading partners which has a negative impact on those funds with high degrees of hedging in place;
- the decline in global stock markets on the back of the Chinese stock market sell-off and ongoing threat of a Greek default.
- specific security or sector factors that impact the individual funds uniquely.
Although we have seen chaos and despair offshore, at home things have been trucking along well with our local bond and share markets holding their own in local currency terms. These bright points will have helped returns, however in some cases not enough to keep some funds above the line.
We continue to see the better funds in each risk category (Conservative/Default, Moderate, Balanced, Growth, and Aggressive) performing well, and higher returns are still being earned if you can accept a greater level of risk.
The under-achievers in each category appear to be making some head-way in closing the gap compared to previous reviews using our unique regular savings model.
It is never a good idea to chop-and-change your fund depending on the current news whim. But when times turn a bit more challenging, it is a good opportunity to review and assess why you have selected the fund you are contributing to.
Assessing track records
Our tracked regular savings model now has $23,747 contributed over the past seven years or so since April 2008. Contributions are rising for two reasons; one is that our model investor is now reaching the peak earnings age range. They started as a 28 year old and they are now 35. As you move up the experience track your earnings rise and your ability to contribute to retirement savings rises too.
And then, the Government raised the minimum contribution levels and the minimum your employer must match. These compound effectively into your fund balances.
It is these rising balances that your fund manager has to work with to earn a return. Our assessment of how well they have done is after all fees and all taxes. Some can't do as well as you could just sticking it in a savings account and that is not a good look for any fund manager. But many others do very much better than you can after all their fees and all taxes.
The bit only you can do
Your job is to figure out how much risk you want to take (based on where you are in your life-cycle of investing) and to find a fund and manager who you will trust to guard and grow your contributions. It is not an easy thing to do, but only you can do it.
It involves thinking things through. You don't need anyone else; you just need to be comfortable with your choice.
Don't try and second guess markets or merely chase recent returns. It is a long game, one where you set-and-forget once you have made choices that make sense for you.
There are a number of resources to help you. Sorted has some. Our reviews and tables will allow you to assess how well various fund managers did in the past for each risk category.
What you need are returns in the future and they are unknowable now. The best anyone can do is to select a risk category they are comfortable with, and a fund manager they are prepared to trust. Knowing their approach to investing is something you can research. Our resources will help with these aspects.
How bonds work
Finally, a primer on how bonds (also referred to as 'fixed income') work, and why risk is involved.
Bonds are not term deposits. A bank term deposit is an illiquid instrument. You don't get your funds back until the end of the term. Over a very long retirement-investment cycle they are not helpful as you just chase yields for the rolled over principal.
Bonds on the other hand are considerably more 'liquid' and there are markets for them. You can buy or sell them and the interest rate they pay (coupon) follows the new owner.
But what the new owner pays for the bond depends on the yield.
For example, consider a brand new bond has come to market, lets call it Bond A. You make a $10,000 investment into Bond A. The interest rate (coupon) is fixed at 6% per annum over the next 5-years until maturity. Each year you receive $600 per annum before tax (based on the 6% coupon). What happens to the value of that bond in one years time if the yield falls to 4%, or rises to 8%?
|Investment Details||Bond A @ 6% yield||Bond A @ 4% yield||Bond A @ 8% yield|
|Date new bond issued||17 July 2015||17 July 2015||17 July 2015|
|Date new bond purchased||17 July 2016||17 July 2016||17 July 2016|
|Interest received p.a||$600||$600||$600|
|Maturity||17 July 2020||17 July 2020||17 July 2020|
|Cost to buy today||$10,000||$10,733||$9,327|
|Profit / (loss)||$0||$733||($673)|
The reason the bond value goes up when yields fall is because the buyer of your investment must pay a premium to secure a level of income that is above what is currently available in the market.
The opposite is also true if yields fall as we can see in the example where the bond is discounted and the investor records a loss if they were to sell the bond at that point in time.
This is why market commentators warn about bond losses in a rising interest rate environment, and report bond gains in a falling interest rate environment.
Your KiwiSaver manager is valuing the underlying investments on a daily basis and reflecting the movements in asset values via the unit price or Net Asset Value (NAV) of the fund.