When equity markets get extremely rocky—as they have no doubt been since mid-February—many investors often seek what they perceive to be safe assets. In our experience, many equate this with fixed-interest securities. In the short term, fixed-interest securities typically see less price volatility than equities—a potentially attractive quality when shares are gyrating. Whilst the ability to dampen volatility in equity portions’ of investors’ portfolios is a useful feature, especially today, we think some take it too far, viewing fixed interest as inherently safe and equities as inherently risky. In our experience, volatile times bolster this perception. But volatility isn’t the only risk investors should consider, in our view—and fixed interest presents a few of its own worth weighing. Now may be an especially difficult time to weigh them rationally, but we think investors still benefit from doing so.
First, there is inflation risk. Most debt securities pay a fixed interest rate. If so, inflation—broadly rising goods and services prices—will reduce the purchasing power of the income received from fixed-interest securities. Inflation risk applies to all asset classes—equities, commodities, fixed interest and especially cash. But higher-returning assets like equities have historically outpaced inflation rates by a wide margin—even taking bear markets into account. For cash and debt, by comparison, the loss of purchasing power can be substantial. Even a 2% annual inflation rate—the eurozone’s historical average—can reduce a currency’s purchasing power by nearly a third over 20 years.[i] Hence, someone investing too much in cash or debt out of a desire for low volatility may actually be taking more risk of running out of money in the longer term.
Up next is reinvestment risk—the danger that when your fixed-interest securities mature (that is, come due for repayment by the issuer), you won’t be able to find replacement securities with a similar yield without taking on more risk. Reinvestment risk materialises when interest rates are broadly falling. For example, French 10-year sovereign debt securities issued in February 2010 paid 3.5% in interest.[ii] Annually, that means an investor would receive €3,500 for every €100,000 in debt they owned. If they held the debt for its entire 10-year existence, they would get back their €100,000 and have earned €35,000 in interest. But when that security expired in February 2020, French 10-year sovereign debt yielded -0.2%.[iii] European investors would struggle to find anything remotely close to the same quality as French sovereign debt paying more than 2%, much less 3.5%.
We think this can present investors holding maturing debt with a difficult choice. They can reinvest the proceeds from the maturing security in an equivalent (but lower-yielding) one and accept the reduced income stream; or they can seek out higher-yielding fixed-interest securities. Some of these, like high-quality corporate debt, are fine. But even these may not reach the 3.5% yield today. That could mean fixed-interest investors focused on yield shift further out on the risk spectrum—increasing volatility. In the process, they risk mitigating fixed interest’s primary portfolio management benefit, in our view.
Default risk (also known as credit risk) refers to the possibility that a fixed-interest security issuer will be unable to make scheduled interest payments or pay back the principal in full. This can occur when the issuer encounters financial difficulties. For example, during the eurozone sovereign debt crisis, Greece defaulted on some of its debt three times in four years—twice in 2012 to an array of private creditors and once to the International Monetary Fund in 2015. More often, corporations run into trouble—like UK travel company Thomas Cook, which suddenly ceased operations and entered bankruptcy protection last September. Default risk is typically highest during a recession (a prolonged, broad-based contraction in economic activity), especially for smaller and more debt-reliant firms. Recently surging yields on lower-rated corporate debt securities likely reflect currently heightened recession fears.[iv] Seeing the interruptions to business from society’s response to the coronavirus, investors seem to be rationally demanding more reward for lending to firms with a higher risk of default. In our view, diversifying across various issuers and issuer types (meaning, corporate and government) is a simple way to limit default risk in your fixed-interest holdings.
Next up: interest rate risk—the potential for broadly rising interest rates to reduce the price of your fixed-interest securities. Fixed-interest prices move in the opposite direction from interest rates. This is because higher interest rates on similar, newly issued securities render them more attractive, so investors likely won’t pay as much for a previously issued, lower-yielding alternative. Longer-term securities—those with later maturity dates—usually carry more interest rate risk. This has to do with “duration”—the length of time it takes for fixed-interest security payments to cover the security’s principal. Those with longer maturities don’t pay that amount back as quickly—hence, their duration is higher. With higher duration comes greater sensitivity to changes in prevailing interest rates. This amplifies a debt security’s price gains when rates are falling and price declines when rates are rising.
Consider Austria, which issued 100-year sovereign debt securities in 2017 with a yield of 2.1%.[v] Thanks to the securities’ very high duration, their prices soared in 2019 as broad interest rates fell over the year’s first three quarters—then again in early 2020.[vi] But these gains could easily reverse. Moreover, these securities’ tendency to swing in response to interest rate wiggles lifts portfolio volatility—again, the opposite of what we think is fixed interest’s primary role in a portfolio.
Finally, liquidity risk refers to the possibility that it will be difficult to sell a fixed-interest security quickly at the desired price. Amongst the many different fixed-interest offerings investors have access to, some trade frequently—like high-grade sovereign debt. It is typically very easy to find a buyer for these securities. But others trade infrequently, making them harder to value. Hence, if you need to sell one of these in a hurry, you may not get your desired price. Making matters worse, many investors may be trying to sell an illiquid security at once, exacerbating the price pressure. In this scenario, even those who do find a buyer may be forced to accept a lower price.
Fixed interest may have a valid home in your portfolio—and may serve the function of reducing portfolio swings. Recent huge market swings underscore this benefit. But you shouldn’t equate lower volatility with riskless, in our view. Every investment has risk.
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Fisher Investments Europe Limited, trading as Fisher Investments UK, is authorised and regulated by the UK Financial Conduct Authority (FCA Number 191609) and is registered in England (Company Number 3850593). Fisher Investments Europe Limited has its registered office at: Level 18, One Canada Square, Canary Wharf, London, E14 5AX, United Kingdom.
Investment management services are provided by Fisher Investments UK’s parent company, Fisher Asset Management, LLC, trading as Fisher Investments, which is established in the US and regulated by the US Securities and Exchange Commission. Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.
[i] Source: FactSet, as of 18/02/2020. Harmonised Index of Consumer Prices, annual rate of change, monthly, January 1991–January 2020.
[ii] Ibid., as of 19/02/2020. French 10-year sovereign debt yield, February 2010.
[iii] Ibid. French 10-year sovereign debt yield, 19/02/2020.
[iv] Source: Federal Reserve Bank of San Francisco, as of 20/3/2020. ICE BofA Euro High Yield Index Effective Yield, 20/2/2020 – 19/3/2020.
[v] “The Buying Frenzy Over a 98-Year Austrian Bond,” Allan Sloan, The Washington Post, 02/08/2019.
[vi] “The $100 Trillion Bond Market’s Coronavirus Mayhem in 13 Charts,” Brian Chappatta, Bloomberg, 7/3/2020; FactSet, as of 19/02/2019. Eurozone 10-year government benchmark debt yield, January–September 2019.