INVESTORS generally invest to maximise their rate of return for a given amount of risk and the current level of interest rates. However, expectations about future interest rates are also important considerations for an investor. The interest rate environment generally refers to the direction in which rates are trending or are expected to move. For whatever reasons (economic, political or credit related) interest rates will rise, fall or remain stable over time and the anticipated movement in interest rates will invariably exert an influence on any investment decision. This article offers some bond investment strategies to explore as interest rates vary over time.

Interest rates in Jamaica are currently at historic lows and many believe that rates can still go lower but at some point in the future the expectation is that rates will increase. So what investment strategy does one employ to maximise returns when interest rates are declining or increasing?

Investing when interest rates are declining

Interest rates have been declining in Jamaica since January 2009 and accelerated in February 2010 following the execution of the government’s debt exchange programme and multilateral support initiatives. Such has been the dramatic reduction in local interest rates that if an investor was offered a 10 per cent per annum rate of return on a one-month Jamaican dollar investment, two years ago, he would think his investment advisor had taken leave of his senses. Today, however, if that same investor was to be offered a 10 per cent rate of return on even a 10-year Jamaican dollar bond, he would be counting his “lucky” stars. In fact, two years ago the 1-month benchmark rate was at 17.00 per cent and 10-year rate around 23.50 per cent; today, the one-month rate is at 6.75 per cent and the 10-year rate is about 8.00 per cent.

In a declining interest rate environment, such as has been the case in Jamaica over the past two years, a bond investor is best advised to invest in a fixed rate bond for the longest period his or her investment horizon (how long until you will need to access your money) will permit. By so doing, the investor is able to obtain relatively higher coupon payments over the life of the bond or his investment horizon. Even if the investor has a short-term investment horizon, he or she can still employ this strategy and then sell the bonds on the secondary market when the funds are needed. The investor would not only benefit from a comparatively higher rate of return (versus a short-term instrument) but also realise capital gains from the sale of the bond given the inverse relationship between bond prices and interest rates. (NB as the interest rate falls bond prices increase and vice versa.) This short-term strategy of investing long term and then selling is only effective where there’s an active and liquid secondary market for that particular bond.

Investing when interest rates are rising

When interest rates are increasing, the general rule is to invest in short-term instruments or long-term floating rate instruments. A short-term investment affords the investor the opportunity to reinvest the maturity proceeds at a higher rate of interest if the expected increase in interest rates materialises. A more adventurous approach, however, could be to invest in a long-term fixed rate bond (earning a higher rate of return than the short-term investment) and then liquidate it on the secondary market to gain access to the principal; but such a strategy is very risky in a rising interest environment as the investor may have difficulty selling a long-dated bond and may even incur a loss of principal. Buying a variable rate bond affords the investor the opportunity to obtain higher coupon payments at each interest reset date (usually quarterly or semi-annually) and also minimise the interest rate sensitivity to an asset portfolio of bonds.

Eugene Stanley is the Manager of Securities and Foreign Exchange Trading at Sterling Asset Management. Sterling provides advisory and financial services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm