Element of risk enters conservative investment portfolios

The word ‘conservative’, particularly when it comes to conservative investment portfolios, usually suggests stable, defensive and steady-as-she-goes, but in these changing times, there are early warning signs that a ‘conservative investment portfolio’ may no longer be the haven that it once was.

Most people who don’t have a huge appetite for risk, often because their earnings potential is declining due to age or because they need the income from their investments, will traditionally opt for a conservative investment portfolio. A conservative portfolio may be 75% bonds and cash, and just 25% of so-called riskier growth assets or shares – but the world is a different place from what it was five or ten years ago.

We are living in times of unprecedented and historic low-interest rates, not just here in New Zealand – where the Reserve Bank of New Zealand just recently left its official cash rate unchanged at 1.75% – but also in many of the world’s major economies.

Interest rates likely to rise

Essentially this means that cash investments are currently returning next to nothing, which puts pressure on people who rely on their investments for income. Meanwhile, inflationary pressures are increasing here in New Zealand and abroad – recent moderations in inflationary growth, due to a fall in energy prices, are unlikely to be long-term as low unemployment continues to exert upward pressure on wages and, as a consequence, prices.

The New Zealand Reserve Bank also needs to keep money flowing through our economy which, as it strengthens, may lead to rising interest rates to balance inflation.

On top of this, economists are also warning that we can expect to see higher interest rates due to positive growth outlooks, possibly early or mid-2018 here in New Zealand, while the Federal Reserve in the United States has already increased interest rates twice this year.

At the moment, New Zealand’s banks are struggling to find cash to lend because the low-interest rate environment is deterring local investors from cash investments. As a result, local banks are having to source funds overseas, where rising interest rates are in turn making those funds more expensive. Ultimately, this will likely cause our banks to increase interest rates locally to attract ‘cheaper’ money.

The upshot is that interest rates are likely to rise and, while this is good for cash investment returns, it’s not so good for the other half of your income portfolio, bonds.

The Effect of Market Interest Rates on Bond Prices and Yield

Bonds can comprise around 40% to 75% of some conservative portfolios.

Traditionally part of a portfolio to offer liquidity and flexibility, bonds can be defined as a ‘debt investment’, because when you buy bonds, you are essentially loaning money to an entity like a corporate or government e.g. government bonds.

A fundamental principle of bond investing is that market interest rates and bond prices generally move in opposite directions (i.e. inversely related). This means when market interest rates rise, prices of fixed-rate bonds fall.

A seesaw, such as the one pictured below, can help you visualise the relationship between market interest rates and bond prices. Imagine that one end of the seesaw represents the market interest rate and the other end represents the price of a fixed-rate bond.

A bond’s yield to maturity shows how much an investor’s money will earn if the bond is held until it matures. For example, let’s say a 10-year bond offers a 3% interest rate, and a year later market interest rates rise to 4%. The bond will still pay a 3% interest rate, making it less valuable than new bonds paying just a 4% interest rate. If you sell the 3% bond before it matures, you will find that its price is lower than it was a year ago.

In summary, conservative investment portfolios may not be that conservative in a rising interest rate environment, as those bonds might have negative returns.

Time to challenge thinking about what’s conservative

Naturally, everybody’s needs are different, and each investment portfolio should be structured according to your individual risk profile, goals and needs – based on professional investment advice – but perhaps it is time to challenge yourself with some ‘outside the square’ thinking when it comes to structuring your conservative investment portfolio.

It is possible to achieve income and liquidity (traditionally viewed as the domain of bonds) from growth assets without being locked into low-yield returning deposits. Managed funds, for example, offer ways to achieve liquidity as well as solid returns, so long as you are prepared to take a portfolio-wide view of your investments.

If you’d like to take the opportunity to review your investment portfolio, contact your financial adviser today on 0800 438 238 or click here to send us an email.

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