Perhaps you have bought a bond, or have invested in a mutual fund that has bonds as a part of its portfolio. You are not alone. The Central Bank's economic bulletin of September 2014 says that Trinbagonians have invested some $34,214.5 million in TT income funds.
Maybe you've been thinking about making an investment in bonds, especially since they have been in the news, with the Government's issue of a $2.5 billion, 12-year, fixed-rate bond at a coupon rate of 2.8 per cent only attracting $1.45 billion, meaning it was undersubscribed by just over $1 billion.
That was the second bond in just over a year that failed to attract the amount of money that the Government had expected, which surprised some market watchers as Government of T&T bonds are almost always heavily oversubscribed.
In August 2013, the Government floated a $1 billion, 10-year, fixed-rate bond at a coupon of 2.5 per cent that only attracted bids of $895 million.
Explaining the failure of the bond to meet its subscription, the Central Bank said: "Institutional investors may have held back from a government bond paying 2.5 per cent in favour of shares owned by the government bank with an indicative dividend yield of 4.75 per cent."
Even if this is one of many possible reasons why the bond was undersubscribed, the importance of the interest rate in the equation is hard to ignore. And bonds share an interesting relationship with interest rates as we will see later. But first, we should get into what are bonds themselves.
Bonds are a debt investment, where a government or corporation essentially borrows money from the public to raise money at a fixed or floating rate of interest.
The Central Bank public education pamphlet, "The Government Securities Market in Trinidad and Tobago" says: "Budget financing is the traditional reason why governments issue securities...To meet a budget shortfall, governments usually raise the shortfall through the issue of medium or long-term securities."
The bond is sold at a par or face value. This is the money that is repaid to investors once the bond matures or reaches the end of its life. There is an interest rate or coupon at which the bond is initially issued. The bond, however, is also subject to the market.
Independent financial consultant, Ian Narine, explained further.
"Most investments have two elements of return. The first is the income that it can generate and the second is any price movement in the investment itself. A bond is no different. There is the income that comes from the interest rate paid and then there is the return that is based on the price movement."
The price movement is caused by prevailing interest rates in an economy as bonds are sensitive to them.
For example, when a bond is bought with a coupon rate of 3 per cent and prevailing interest rates increase by 1 per cent, anyone hoping to buy the bond would want to pay less for it, as they would have to forego the returns offered at 4 per cent.
Conversely, if a bond is issued at 5 per cent interest and prevailing interest rates decrease to 3 per cent, purchasers would be willing to pay more for it as it offers a higher rate of return in a low-interest rate environment. Remember, the interest rate for bonds is fixed.
Bonds, therefore, experience an inverse relationship with interest rates. When interest rates increase, the price of bonds decrease and when rates fall, the price of bonds increases.
So how does this affect you if you have invested in bonds, in a mutual fund that has bonds as part of its porfolio, or you have invested in a bond fund, which is an combination of different bonds in a fund ?
Narine said in the case of a bond fund, investors could see themselves losing.
"The value of the portfolio is the sum of the price of all the bonds in the portfolio. If therefore interest rates are rising then, all other things being equal, the price of the bonds in the portfolio will fall. A falling price will mean a lower portfolio value."
He said the challenge here would be for the portfolio manager to manage the price movements so that "the value of portfolio is as stable as possible thus allowing the investor to benefit from the income generated by the fund."
Interest rates, or more specifically, the repo rate has risen by 50 basis points over the past three months from 2.75 per cent to 3.25 per cent.
In considering what this change in interest rate may mean for investors, Narine said one has to consider that there are different interest rates.
"When we speak about rising interest rates we have to appreciate that there are many different interest rates. There are borrowing rates, such as when you go for a loan and there are deposit rates which is the rate you get for a deposit."
The financial consultant also noted that interest rates were affected by time.
"You would expect to pay a higher interest rate if you borrow money for one year than if you were borrowing for ten. When we speak about rising interest rates we have to appreciate that lending rates will be impacted differently to deposit rates and shorter term interest rates will be impacted differently to longer term rates. The key is to understand that the same factor will have different influences and to different extents."
Drawing reference to the repo rate, Narine said, so far, this has only affected the prime lending rate of banks.
"It may serve as a reference point but it will not affect long-term interest rates to the same extent as it will affect short-term interest rates."
He said the US situation was more pronounced.
"As the expectation is that the US Federal Reserve will soon signal an increase in their short-term lending rate to banks the two-year interest rate in the US has moved up and recently went to 0.6 per cent. On the other hand, because of the turmoil in the oil market and other fears about the global economy investors are looking to place their funds in the 10-year US treasury bond. The increased demand has resulted in the price to rise and rising price translates into a lower yield. The US 10-year is now yielding 2.09 per cent when the predictions by many at the start of the year was for this benchmark to be at around 3.5 to 3.75 per cent by this time.
"This means that long term interest rates in the US are in fact falling while short term rates are rising."
In contrast, Narine said, while T&T is experiencing a short-term rise in interest rates, the long-term outlook was as yet unclear.
"What may trigger a rise in longer term rates is the fact that oil prices have fallen and so with less revenues available there is greater risk in lending longer term in T&T. That may cause investors to demand a higher interest rate as compensation for the increased risk of lending in this environment."
Narine also said government had to watch T&T interest rates versus those of the US considering the shortages of US currency that have struck the country, since there was the potential for the problem to become worse as interest rate differentials could cause investors to send foreign currency outside.
"Recently the Governor of the Central Bank suggested that there is hoarding of US dollars. One way to address this is to create an environment for higher TT dollar interest rates. Using the 10-year rate to illustrate, I can invest in the US 10-year at the current 2.10 per cent. Let's say the equivalent investment in TT$ generates a return of 2.6 per cent. That � per cent differential has to compensate me for taking T&T-dollar risk. If it is not sufficient compensation then one may prefer to hold an investment in US dollars."
Narine said if prevailing interest rates went to 4 per cent, for example, it may provide an incentive for investors to hold an investment in TT dollars, increasing the demand for TT dollars compared to US.
"It is early days yet in terms of the upward movement in TT interest rates but these are the types of issues that are in play at present. How much and how quickly interest rates rise will be determined by a number of different factors some of which may originate locally but others will be thrust upon us by events outside of T&T. As you can see there are many different issues to consider." said Narine.
Kurt Valley, General Manager, First Citizens Asset Management Limited said:
When interest rates rise bond prices always fall. In Trinidad we have many fixed NAV (Net Asset Value) funds where the price of the units is set at a fixed level. For instance, the unit value of the First Citizens Abercrombie fund is set at $20. When interest rates rise, the bonds in this fund will be valued lower but to the customer nothing will change in the short run. Over time, rising interest rates will necessitate the payout rate on these fixed NAV funds to increase.
We also have floating NAV funds such as the El Tucuche fund. This fund's value is very responsive to interest rate changes and would rise when interest rates are falling and fall when the general level of interest rates is rising.
Investors would need to understand which type ofbond fund they have and their investment objectives to determine which type of fund would work best for them in a rising interest rate environment.
Natalie Mansoor, Head Asset Management, RBC Investment Management (Caribbean) Limited had this to say on the issue:
The interest rate that is applied to any bond is really comprised of two separate rates: 1) the applicable risk-free rate and 2) the spread applied for the specific credit risk of the specific bond.
Generally, when a reference is made to "rising rates" it is usually the risk-free rate that is being discussed. The risk-free rate is usually the government bond rate associated with the currency of the bond issue: so for example for TTD denominated bonds the risk-free rate is a GORTT bond, for USD bonds the risk-free rate is the US Treasury bond rate and for EUR denominated bonds the risk-free rate is the German Bund rate.
Interest rate increases will be seen first in the risk-free bond and because there is no credit spread applied to the risk-free rate, a rise in these rates will result in a decline in bond value.
For risk assets - i.e. bonds that are not the risk-free bond - there is a spread that is applied to the risk-free rate. Therefore, to determine how these prices will move will not only be a function of the movement of the risk-free rate but we also have to look at the potential movement in the credit spread. Credit spreads are generally a reflection of the level of confidence (or lack thereof) that investors have in the credit as well as the overall economy: so when confidence is high, spreads tend to narrow and conversely when there is fear or uncertainty, spreads will widen.
Therefore when we discuss rising rates, to determine how spreads will react, we have to look at the overall economy into which these rising rates will be applied - if it is a weak, slow-growing economy where confidence is already low, then you will find that investors will react negatively to rising rates by widening credit spreads resulting in sharp declines in bond prices.
If the economy is a strong economy, particularly with strong confidence reflected in strong lending/low liquidity, then you may see spreads narrow - possibly enough to offset the increase in the risk-free rate. In this situation you will see little movement in bond prices or you can actually see an increase in bond prices if the spread narrows sufficiently (i.e. the decline in spread is more than the increase in the risk-free rate).
In T&T where there is significant excess liquidity, it will be difficult to maintain a sustained rate increase until this liquidity is removed. As such, if the liquidity remains and rates are pushed up, the most likely consequence will be volatility as rates get pushed up but then fall again as liquidity builds up. Ultimately whether interest rates go up or down investing in bonds is about earning income over a medium to long time horizon, not capital appreciation. Once you match the investment with the right objective then you will be fine.