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Over the last three months, we have seen the long-term interest rates (i.e. bond yields) throughout the
world rise by 1%. What has happened in NZ is typical of what has happened globally. The graph below
shows the 10-year NZ government bond yield since 1 May 2013.

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The rise in yields over the last 3 months needs to be considered in the context of yields that have
generally fallen over the last 30 years.

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What does this mean?

With a rise in bond yields, it means that the future average return will be slightly higher. But it also
means that recent returns are negative. The general principle is “when interest rates rise, the value of
existing bonds goes down” - no one wants to buy lower yielding bonds at $1 in the $1, when they can get
a higher return by buying a new bond. As a rough rule of thumb, a 1% rise in bond yields leads to an
immediate 4% decline in value. The opposite occurs when interest rates fall. Of course, if you do not
sell the bond, the value slowly goes back to $1 as it approaches maturity, as on maturity you receive the
full amount.

Therefore, investors who have invested in bonds will have seen very good returns over the last 30 years
due to interest rates falling, but negative returns over the last 3 months, simply because of the change in
bond yields.

The average return from a bond over the long-term is equal to the yield. However, the return from
bonds over the short-term is equal to the yield, adjusted for the short-term market movement. This can
be seen by looking at the returns over the last 6 months.

Investors who have invested in bonds will have a return before tax for the six months (1 January 2013 to
30 June 2013) of -1.3%. Over this period, interest rates started at 3.53% and rose, ending up 0.6% at
4.13%. The negative return reflects the reduction in the bond value due to the increased interest rates.
The -1.3% is made up of the loss in capital of -3.1% offset by the interest paid for half a year of 1.8% (of
3.5%).

This -1.3% return can also be looked at in two periods. First, the period to 30 April 2013 when yields
generally fell and second, since 1 May 2013 when they rose. From 1 January 2013 to 1 May 2013,
investors got a return of 2.4% i.e. 4 months of the 3.53% plus 1.2% capital gain (from the 0.36% fall in
rates). Then, for the period 1 May 2013 to 30 June 2013 when interest rates rose, the return was 2
months of the 3.17% (i.e. 0.53%) offset by the -4.1% due to the rise in interest rates of nearly 1%.

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In practice, it is not as simple as the above, because the market is made up of a range of bonds and not
just 10-year bonds, but it illustrates the point that the return short-term is made up of the yield at the
start and the market movement. Long-term, the average return is equal to the yield as the positive and
negative market movements offset each other.

Observations and lessons

With bonds, it is important not to have a “kneejerk” reaction to rises in interest rates and to look
through short-term market movements. It is better to look at the returns from bonds over a 2 to 3 year
period. Sometimes, it may be better not to invest in bonds if you are going to spend the money in the
short-term, unless you are prepared to take the risk of a loss. Bonds often decline over the short-term.

There is a lot of commentary around at present about the likelihood of interest rates, and bond yields in
particular, continuing to rise. We do not know whether they will or will not, as they will be driven by
events beyond our control, like the recent US Federal Reserve talk of reducing its quantitative easing
policy (“printing money”). If they do rise, there will be a period of low returns from bonds. The way to
manage this risk is to ensure you will not have to sell the bonds to realise cash to spend.

We think that there will be volatility, but that any material and permanent rise in bond yields is still not
likely until the second half of 2014 at the earliest. In our managed strategies, we continue to hold bonds
in preference to cash and expect to until mid 2014. Over this period, we expect bonds to do better than
cash. However, we also expect that there will be several months, like May and June 2013, when the
reverse happens.