More interest rate hikes to come? Savers move to fixed income funds like bonds: Here's what you should know before you buy them Image Credit: Shutterstock

Dubai: With interest rates rising worldwide, and with more to come, experts recommend an investment approach that is focused on preservation of income, which simply involves setting aside your hard-earned money in fixed income assets like bonds. Furthermore, the time to do so can’t get better than now with the UAE government having launched its first government bond last week.

What are fixed income assets? The term ‘fixed income’ refers to the interest payments that an investor receives and it generally includes different types of bonds or other debt assets that gives the owner the right to receive a stated, fixed sum of money on a specified date.

In simple terms, what is a bond?
In simple terms, a bond is a loan from an investor to a borrower such as a company or government. The borrower uses the money to fund its operations, and the investor receives interest on the investment. The market value of a bond can change over time.

In exchange for the investor’s investment, the borrower pays an interest coupon, which is the annual interest rate paid at predetermined intervals (usually annually or semi-annually) and returns the principal (borrowed amount) on the maturity date, ending the loan.

So while the term ‘fixed income’ refers to the interest payments that an investor receives, which are based on the creditworthiness of the borrower and current interest rates, fixed income securities are often recognised as bonds that pay a higher interest (coupon).

Moreover, with central banks hiking interest rates worldwide, here’s why your savings set aside in fixed income assets like bonds stand to benefit. This is because interest rates share an inverse relationship with bonds, so when rates rise, bonds tend to fall and vice versa.

How government bonds work

A bond is simply a vehicle that governments and companies use to borrow money. People buy bonds, and in exchange, receive interest payments. Our country would barely be able to function without bonds.

For the sake of this discussion, let's focus on government bonds. Globally, almost every government floats many different type of securities, but the most common are the 30-year and 10-year Treasury bonds.

These bonds pay interest every six months, and the principal amount of the bond — often referred to as the original amount or "par value" — is paid in full after 30 or 10 years.

There are also popular securities called inflation-protected securities. The principal amount of inflation-protected securities can go up or down depending on the movement of inflation, which is otherwise tracked by the consumer price index or CPI.

Government bonds are very popular worldwide because they are backed by the full faith and credit of the government, which has historically always repaid its debts.

A bond is simply a vehicle that governments and companies use to borrow money.

The UAE launched its first government bond last week

Bond yield and price: What are they?

If you plan to hold onto a bond until it matures, you'll likely want to take a look at its yield, which is simply a calculation of how much money you'll make on the investment.

So for example, let's say you have a Dh10,000 30-year bond with an annual interest rate of 5 per cent. This would mean you'd get Dh500 per year. This is the bond's annual yield. It's also referred to as the "nominal" yield.

There's another factor that determines how much money you make from a bond, and that is price.

Let's say that the owner of the Dh10,000 bond above chooses to sell the bond before it matures, for Dh9,000.

The buyer of the bond will still continue to get interest payments based on the face value of the bond (Dh10,000). These interest payments are fixed.

Thus, the buyer is receiving the same payments, but because the buyer paid less for the bond, the yield is 5.55 per cent. (Dh500/Dh9,000)=0.0555, or 5.55 per cent).

When a bond is selling for more than its issue value, we often hear people say it is trading "at a premium.“. If it is selling at less than its issue value, it is selling “at a discount”.

Generally speaking, people seek to find bonds selling at a discount, because they result in a higher yield.

What does it mean when a bond trades at a premium or discount?
A discount is the opposite of a premium. When a bond is sold for more than the par value, it sells at a premium. Conversely to a discount, a premium occurs when the bond has a higher interest rate than the market interest rate (or a better company history).

Why do bond prices rise and fall?

The price of bonds is very closely impacted by a country’s interest rates. The prevailing interest rate — that is, the interest rate on bonds being issued at that particular time — can make any other bond seem more or less attractive to investors.

To illustrate this, let's say you hold a 30-year bond with a 5 per cent interest rate, but rates have been rising and now average 6 per cent. Because your bond now has an interest rate that is lower than the prevailing average, it's less attractive to investors.

Thus, if you want to sell the bond, you may have to lower the price to ensure investors can get the same yield. The opposite is also true. When interest rates are falling, any bond with a higher interest rate becomes more attractive and can demand a higher price.

Inflation is known to indirectly impact bond prices because it is accompanied by higher interest rates. Bond prices are also indirectly impacted by the performance of the stock market.

Those lessons about interest rates need reworking
The price of bonds is very closely impacted by a country’s interest rates.

How can I invest in fixed income?

It's possible for an individual investor to buy a single bond or other fixed income assets. Individuals can invest in fixed income through mutual funds and exchange-traded funds.

A mutual fund or an exchange-traded fund are types of financial vehicles made up of a pool of money collected from many investors to invest in different assets traded on the stock market.

However, it requires a significant amount of investment to build a diversified portfolio of individual bonds. What makes it difficult for individuals to buy and sell many types of fixed income securities? High minimum investment requirements, high transaction costs and a lack of liquidity in the bond market.

Bonds are a great way to earn income because they tend to be relatively safe investments. But, just like any other investment, they do come with certain risks. Here are some of the most common risks with these investments.

3 key risks to putting money in bonds

#1: Risks associated with prepayment

Prepayment risk is the risk that a given bond will be repaid back to you much sooner than the expected bond maturity date.

This can be bad for investors because the borrower only has an incentive to repay the bonds early when interest rates have declined substantially.

Instead of continuing to hold a high-interest investment, investors are left to reinvest funds in a lower interest rate environment. But with interest rates higher, this risk is considerably lowered.

#2: Risks associated with interest rates

Interest rate risk comes when rates change significantly from what the investor expected. If interest rates decline significantly, the investor faces the possibility of prepayment.

If interest rates rise, the investor will be stuck with a bond that yields him or her rates that are below the market’s current value.

Experts opine how the greater the time to maturity, the greater the interest rate risk an investor bears, because it is harder to predict market developments farther out into the future.

#3: Risks associated with credit or default risk

Credit or default risk is the risk that interest and other payments due on the bond will not be made as required.

When an investor buys a bond, they expect that the issuer will make good on the interest and principal payments – just like any other creditor.

When an investor looks into company-issued bonds, they should weigh out the possibility that the company may default on the debt.

Inflation rate
Investors should have a plan to put their money in assets that typically outperform the market, especially during times of high inflation and interest rates.

Verdict: Are bonds a good way to protect my money when inflation and interest rates are high?

Investors should have a plan to put their money in assets that typically outperform the market, especially during times of high inflation and interest rates.

In any case, you want to make sure your investment portfolio is well-diversified, but increasing certain types of securities, like bonds, may be a good choice when inflation and higher interest rates hit.

A common way investors usually hedge against inflation is by buying fixed incomes assets like bonds, since the principal (main amount) is adjusted based on inflation.

This makes them a valuable investment for anyone looking to ensure the fixed-income portion of their portfolio matches with rising inflation.

However, it's important to assess your financial goals, age, and other factors like your risk tolerance to determine how much of your portfolio you should allocate to bonds, and what types to purchase.

In many cases, experts advise that bond ETFs (exchange-traded funds) are a good choice since you can diversify your portfolio across different kinds of bonds.

What are bond ETFs?
Bond exchange-traded funds (ETFs) are a type of exchange-traded fund (ETF) that exclusively invests in bonds. (An exchange-traded fund (ETF) is a basket of securities that tracks an underlying index.)

If you plan to buy and sell frequently, bond ETFs are a good choice. For long-term, buy-and-hold investors, bond mutual funds, and bond ETFs can meet your needs, but it's best to do your research as to the holdings in each fund.

For those who can meet the minimum purchase requirements for government bonds, it may be worth considering since they offer as much stability as company issued ones.

It’s important to do your research to understand your risk tolerance. Like other types of investments, it’s helpful to have a plan for your bonds, so if you decide to sell before the reach maturity you understand the financial consequences.