At large: Ross Greenwood

Rising bond yields could have far-reaching repercussions beyond higher home loan rates

Of all the economic numbers an investor should watch this year, bond yields (or interest rates on government and corporate bonds) are perhaps first among them. The change in market rates is a direct reflection of the risks you take in your investments, and prices will change accordingly. Some of it has already happened but more is to come.

Interest rates generally rise when there is more demand for debt and less demand for government and corporate securities. This is the opposite of the past nine years, when Western governments, in the aftermath of the GFC, cut interest rates to stimulate demand, then issued trillions of dollars of bonds (debt) to keep their banking systems and economies afloat.

Lots of bonds (government debt) floating around meant record low interest rates (even negative interest rates in places such as Japan and Germany). In Australia, where government debt is relatively modest compared with other places (though rising at a worrying pace), rates were cut as a reflection of what was happening in other parts of the world.

The result of low interest rates was, in some places, a boom in house and bank share prices. House prices increased because cheap money allowed buyers to afford more. Bank shares increased because the yield from their dividends – relative to government bonds – was attractive, so investors bought in heavily.

But if, as appears, rates are rising around the world, then the opposite should occur (I say should because the way these things occur is never perfect). The US is raising rates because its economy is picking up and the Federal Reserve wants to wind back the trillions of dollars in economic stimulus (and government debt).

That, in turn, means bond yields around the world are rising. In Australia, around 12 months ago, government bond yields were below 1.9% – an all-time low. Today the rate is around 2.8%. This rate, plus rising shorterterm interest rates, is the justification for banks starting to raise interest rates on many of their lending products.

There’s another reason: the banks know that if rates rise there is more risk of falling property prices (especially in housing, which in some states has had a huge run). They are trying to de-risk their portfolios by making credit either more expensive or more difficult to obtain (note that some banks are refusing to refinance noncustomers’ investment property loans).

The other people who need to keep an eye out are investors and savers who sought returns through the low-interest cycle. Those who are especially exposed, if interest rates keep rising, are those in illiquid investments including mortgage trusts and unlisted property trusts or syndicates.

The issue here is that if rates rise, several things may occur. There could be a hurried exit by many investors in a short time, triggering a suspension of redemptions (this has happened more than once before). Another worry would be falling prices in the assets underlying the investments.

Another way that investors have sought higher income returns is through so-called hybrid securities issued by banks and other major companies. For them the securities provide a source of lower-cost funds, while for investors they provide a higher return than might be achieved in bank term deposits. I have owned some through my self-managed super fund and, in the main, they have performed well.

But I have always been conscious of the comment by financial literacy expert Robert Drake: “Some hybrid securities make investors take on ‘equity-like risks but only give them, at best, ‘bond-like returns’.”

You can generally find these securities through financial planners. The chart (below left) created by fixed-interest specialist FIIG Securities shows some of the different ways companies will raise money from investors, with the relative risk and returns alongside. You would be wise to never lose sight of those risks.

If you go through the hybrid and corporate debt on issue right now (FIIG has a complete list on its website), the thing that strikes you is the difference in the rates. Some have a running yield of 7.5% for the next four years. Others, such as Sydney Airport, offer 3.5% out until 2020. The difference is in the perceived risk of the investments.

So what’s the risk? Well, one is that you won’t be paid back your capital when it comes due. The other is that you won’t be paid the interest as promised. And if interest rates generally start rising, then those risks will also be seen to increase.