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If your main priority is income, then fixed
income investments can offer advantages. However, investors
who rely solely on only a few fixed rate and term deposit
type investments are exposed to two types of risk: reinvestment
risk and market volatility.
Reinvestment risk
Like all investment markets, interest rates
go up and down depending on the economic climate and circumstances.
A drop in interest rates will mean that when your investment
matures, your capital will be reinvested at a lower rate.
This means your new investment will provide
a lower level of income. And because there is no capital
growth component with a fixed income investment, there's
no extra capital available to boost your reduced income
level.
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Sylvia
Age 72
As a retiree, Sylvia relies on her investments for
income. "I had always favoured fixed rate and
term deposit type products, because I knew exactly
where my income would be and I could plan my expenses
around it," she says.
Back in the 1980s, Sylvia got used to earning about
16% from fixed rate investments, which gave her a
tidy sum to live on and peace of mind. "I thought
I could go on like that forever, rolling over my investments
as they matured - how wrong I was!"
In 1992 when Sylvia went to roll over her maturing
term deposits, the rate at which she could reinvest
was significantly lower than than the rate she was
used to. And because there had been no growth component
to her investment, there was no extra capital to top-up
her lower income.
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Market volatility
Fixed interest investments (such as Government Bonds) tend
to pay a fixed income (known as the coupon payment) which
is set when the bond is first issued.
Since the coupon payment is fixed, movements in market
interest rates affect bond prices. The following table shows
the basic inverse relationship between interest rates and
bond prices, where a rise in interest rates leads to a fall
in bond prices and vice versa. In other words, if you needed
to sell your bond investment in the case of an emergency,
the price at which you sell your bond will depend on the
interest rates at the time. If the interest rates have increased
between the time you purchased your bond and the time you
sell it, you may have to sell the bond at a price lower
than the value you would have received upon maturity, incurring
a capital loss. For example, a 5 year bond worth $100,000*
when interest rates are 5% pa would be worth approximately
$96,000 if interest rates were to rise to 6% pa.
Fluctuating interest rates can not only dramatically affect
your income returns, but can affect also your capital value
in the short term as well.
* 5% pa coupons payable half-yearly
assumed.
| Impact of movement in interest rates on bond prices |
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Interest rates
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Bond Prices
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Increase in interest rates
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...falling bond prices
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Declining interest rates...
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...higher bond prices
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