Unhedged corporate bonds deliver capital losses

A number of prominent corporate bond funds have delivered negative returns for the first half of the year. This has come as a surprise to some investors - particularly those who have seen domestic and global shares deliver positive returns as talk of 'green shoots' of economic recovery spreads.

The culprit this time is not bond defaults but a sharp rise in long-term interest rates. Ten-year interest rates have risen 1.56% in the past six months. When interest rates increase, corporate bonds - which offer a fixed return to maturity - tend to drop in value to a level that ensures the purchaser of the bond will get the new, higher rate of interest. The daily pricing of some corporate bond funds has led to negative returns over the past six months as interest rates have been rising over this period.

"Following the difficulties associated with finance companies and mortgage funds last year, investors have rightly focused on investing in corporate bonds issued by high-quality household names," says Michael Lang, Chief Investment Officer at investment management company, New Zealand Funds Management Ltd, which oversees approximately $310m of bond investments.

"Investors are worried about the possibility of default and are therefore focused on the quality of the issuer. Although this is logical, what many fail to appreciate is that when interest rates go up the resale value of corporate bonds tend to go down - even if they have not defaulted."

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