KEY POINTS:
Since the credit crisis spoiled the party around June of this year the local secondary bond markets, where the likes of government stock, bank and other corporate bonds are bought and sold, have increasingly differentiated between "safe" and "not so safe" issuers.
This is normal behaviour in a crisis. Economists even have a name for it - bifurcation - whereby yields on safe bonds go down and yields on dodgy ones rise.
In the past 12 months we have seen, in respect of the former group, the interest rate on 10 year government bonds fall from 6.25 per cent to just 5.64 per cent presently. In the same period the yields on bonds of companies that are viewed as being more risky have risen, in some cases, by a very large amount.
Finance company debentures are an extreme example - the chance of debenture owners being repaid in full is slight so many debentures, if they were listed, would trade at a discount of maybe 20 cents in the dollar.
But finance companies haven't a monopoly on plunging bond prices. Many New Zealand retail investors who were sensible enough to give debentures a miss have seen their nest eggs sustain substantial collateral damage as a result of a sharply deteriorated outlook for the company whose bonds they own and a declining appetite for risk.
Examples are St Laurence Group 2011 bonds, issued at 9.25 per cent, whose yield in the secondary market increased from 9.75 per cent in June 07 to 25.05 per cent recently, and Babcock & Brown 2011 bonds, issued at 9.0 per cent, and whose yield in the secondary market has blown out from 8.9 per cent in June 2007 to 90 per cent recently. Yes, 90 per cent a year.
At first glance you might think that doesn't sound bad - receiving a higher interest rate is a good thing, surely?
Unfortunately the way the yields on these bonds have risen is due to their prices falling, not because they are paying out more money. For example, the price of St Laurence bonds has fallen from $98.37 per $100 face value to $71.16, and Babcock and Brown bonds have plunged from $100 to $20.10 per $100 of face value.
Losses of this magnitude illustrate that while bonds as an asset class are less risky than shares, some bonds are actually more risky than some shares and many of the same rules, like diversification, still apply.
I reviewed a portfolio the other day managed, or I should say mismanaged, by a financial planner where the bond portfolio comprised just four corporate bonds, one of which, unfortunately, was the aforementioned downwardly spiralling Babcock & Brown 2011s.
This family trust had bought into the Babcock & Brown bonds when they were originally issued. The loss here was so great that the return on the entire bond portfolio over the past three years was negative.
Their experience raises some important issues in the management of a bond portfolio: first, the naive model of "beat the bank" by simply picking the highest interest rate frequently doesn't work. As Homer Simpson might have said, doh! Bond markets are efficient.
Secondly, given the small number of corporate bonds on issue, and the absence of any reasonably priced bond funds, a sensible, low-risk and low-cost way of managing a fixed-interest portfolio is through owning a mix of short, medium and long-term bonds, but limiting the choice to those issued by either government-owned companies or which are too big to fail.
Simply buying three or four corporate bonds paying high interest that your adviser happens to have for sale that day isn't prudent because the theory from Harvard University says you need to own at least 50 risky bonds to be diversified properly.
That strategy is not feasible for most investors and nor is a managed fund an option because high fees bring you back to the return of bank deposits again.
Where many mums and dads have come unstuck is through owning just five or so risky corporate bonds and getting stung with a St Laurence or a Babcock & Brown or, before that, a Feltex, and before that, Fortex, and before that, Metropolis. The list of disasters is a long one. The end result for many is that returns go well below what they could have got in the bank for less trouble and strife.
This strategy has affected many retirement portfolios in New Zealand and the culprit is often advisers' high annual fee structures.
Relatively low-risk bond portfolios yielding 8 per cent or so can't sustain annual fees to advisers of 1 per cent and higher, so the adviser is pushed by his or her fee structure into the high-yield area which, with insufficient diversification, can mean substantial collateral damage for retail investors.
Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.
