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Have Conservative Funds become Riskier?

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Stuff posted an article last week entitled “KiwiSaver investors told: Conservative funds have become riskier”1.

This article explains what they meant by this statement, but also why it is fundamentally wrong. It does highlight something that investors should be aware of though.

 

So why conservative funds specifically?

This is all about bonds and how they perform when interest rates go up. Generally, more conservative funds invest in more bonds (up to 80% sometimes), and more aggressive funds have more shares (and therefore less bonds).

What is a bond?

The easiest way to think of a bond is to view it similarly to a term deposit, but issued by a company.

Let’s say Company A wants to expand but doesn’t want to borrow money from the bank. They need to borrow $100 million and know that they can pay it back in 5 years’ time. If the company is big enough and well known enough, it can issue a bond.  They essentially say “People of New Zealand (or another country), we want to borrow a total of $100 million, and will pay you back in 5 years’ time. Who will lend us some money?”

Now, this Company A, is not as safe as a bank. If you have $10,000 kicking around, you want to make sure it’s safe. You could put it in the bank, but now that might get you only 1% interest (if you’re lucky). To reflect that Company A is a slightly riskier option, they have to offer a better rate of interest, so may offer 2% for example.

So, you weigh up if getting 2% interest is worth the increased risk of lending your money to Company A. You’re pretty confident that you’ll get it back off them at the repayment date in 5 years’ time and are happy to get the 2% a year in interest, so you buy the bond, and lend the money.

That’s your bond!

Lots of companies issue bonds all over the world, so in your conservative fund, you don’t just have 1 or 2 bonds, you have very many bonds from companies all over the world operating ain all sorts of different sectors.

 

What’s the issue if interest rates go up then?

A big difference between a bond and a Term Deposit, is that there’s what’s called a “secondary market” for bonds, meaning that you can sell them at any time up until the maturity date. You can’t do this with a Term Deposit so are stuck with your 1% for the whole term.

Let’s use the Company A bond example again.

You’re getting an interest rate of 2%, and let’s say you’re 4 years in to the 5 year bond, so know that you’ll get paid your $10,000 back in 1 years’ time.

Interest rates have now gone up to 4%, so if you had your $10,000, you could now put it in the bank and get 4%. This is WAY better than the 2% you’re getting on your bond.

So, you try to sell your bond. Will anyone pay you the $10,000 today knowing that they will get half of the interest they’d get in the bank? Probably not, especially as they’d be taking on more risk.

So, how much could you sell your bond for (this example has been highly simplified)?

Your bond will pay you $200 in interest (2% of $10,000).

In the bank, you could get $400 interest on a $10,000 Term Deposit (4% of $10,000).

So even assuming no difference in risk, the maximum you’d be able to sell your bond for would be the $10,000 you’ll get back in a year, less the $200 difference in interest that someone would be giving up if they bought your bond rather than put the money in the bank.

If interest rates go up to 4%, the price of your bond goes down to $9,800.

If interest rates go up, bond prices go down.

(The opposite is true as well, so if interest rates go down, your bond would become more valuable as it’s paying more interest.)

 

What does this mean for conservative funds?

As interest rates are really low at the moment, and there’s not much downward movement expected, the only way is up. This might sound good, and for cash investors it will be, but it does mean that bond prices are going to go down as we see interest rates rising.

As conservative funds hold mainly bonds, this will impact the returns.

 

Can I do anything about this?

Within your fund, a lot is already done to manage this.

Fund managers do what’s called laddering. This means that they don’t have all of the bonds maturing (finishing) in 5 years’ time. They have bought lots of different bonds over time, that are all maturing at different times. If interest rates do go up, then the bonds that mature this year will pay out money that can be reinvested in the new, higher interest rate. More will mature in 2 years and 3 years and so on. This picture illustrates it quite well:

What also happens is that Conservative funds still usually do have some exposure to shares. Whilst rising interest rates may have a negative impact on bond prices, it doesn’t necessarily have the same effect on shares. This is called diversification, or not having all your eggs in one basket.

 

Are conservative funds getting riskier then?

This is where I think they’ve got it wrong in the article. No, they aren’t getting riskier. You are still taking the same level of risk, and no one is increasing that without you knowing.

We are faced with risks all the time with our investments, and when fund managers, or Booster, calculate expected returns and risk levels within funds, they do so based on a 20 year time frame. Over this length of time, we expect ups and downs, and all of this is factored into the make up of the funds when they are put together.

There are a lot of risks around at the moment, but there are always a lot of risks around. Some we know about and some we don’t. This is why diversification is so important, and also why it is incredibly important to invest according to your own timeframe and risk appetite. Risks aren’t increasing, but the media is making us all a lot more aware of them at the moment.

 

What should I do?

Don’t panic or react just because you’ve read something or heard something. Plan and invest based on your own time frame and risk appetite and ask for advice. If you’re a client of ours already, you are paying for advice either within your investment or KiwiSaver fund, so there is nothing extra to pay if you want a review or have questions.

Stick to your own plan and don’t let the media or anyone else try to pull you off course.

 

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  1. KiwiSaver investors told: Conservative funds have become riskier | Stuff.co.nz