Debts that pay

By MARK FRYER

Words like "safe" and "secure" don't usually leap to mind when you think about investing on the stock exchange.

Lately, however, the local exchange has been promoting a form of investment where safety and security are the big attractions.

The exchange has been reminding investors that it isn't just a place where shares are bought and sold. Its other role is as a marketplace for various types of fixed- interest investments.

That's nothing new - sharebrokers have been selling investments such as government stock and corporate bonds for many years. But that side of the market tends to attract less attention than the more glamorous business of share trading.

As a result, fixed-interest investing can be a bit of a mystery.

Here's Weekend Money's beginners' guide to that "other" investment market.

What's on offer here?

In the jargon, what's on offer are "debt securities" - fixed- interest investments with some special features.

To start at the beginning, those investments are created when companies - and the government, and local bodies - want to raise money.

They ask the public for cash. In exchange, investors get a promise that they will get back their money later, and will receive interest payments in the meantime.

The original investors can then sit back and receive the interest payments, and get back their original investment when the time comes.

Or, if they want their money back sooner, the original investors can sell those promises to someone else, who is then entitled to the interest and the final payment.

The fact that they can be bought and sold is one of the main differences between this type of fixed-interest investment and more familiar alternatives, like bank term deposits.

What's the attraction?

The obvious attraction is the chance to get a regular income.

How much income depends on how much risk you want to take. At present, some fixed-interest investments of this type are returning as little as 4.5 per cent or so (for some government stock). Less secure, but still highly regarded, investments are paying anything up to 7 per cent or so. And returns can be much higher if you're particularly brave, or foolhardy.

The other attraction is diversification, also known as not having all your eggs in one basket. While most investment experts will tell you shares offer the best long-term prospects, many investors like to have some money in fixed interest to cushion the inevitable sharemarket falls.

And if you're looking for a long-term investment, these certainly fit the bill; some government stock runs for 15 years.

Shares and debt - what's the difference?

If you buy shares in a company you become a part-owner. Your returns come from dividends and rising share prices, neither of which are guaranteed.

Invest in debt, on the other hand, and you're one of the company's creditors - it owes you money. Your returns now come in the form of set interest payments. Unlike shareholders, the company undertakes to give you your initial investment back (if you hold it to maturity). If the company goes bust, debt investors are more likely to get a payout than shareholders are.

Now for some jargon

Even the most jargon-averse investor needs to know a few key words before putting money into this sort of thing. Among the most important:

Face value: the amount the original investor loaned to the company raising the money. To put it another way, it's the amount you'll get back if you hold the investment at maturity date.

Maturity date: when the investment runs out and you get back the amount originally invested. Not all fixed-interest investments have one - some are "perpetual" and, in theory, can run forever.

Coupon rate: the interest rate, which is based on the face value. If you buy a fixed- interest investment with a $10,000 face value and an 8 per cent coupon, you'll get $800 a year, typically paid quarterly or half-yearly.

Yield: the total return on your investment, between the time you buy it and the maturity date, expressed as a percentage. And no, it's not necessarily the same thing as the coupon rate (see 'What if I get out early?', below).

What are the risks?

First, there's the obvious danger - the company whose investments you buy may not be able to make good on its promises. At worst, if it goes bust, you could lose your entire investment.

You can reduce that danger by sticking to the most solid companies.

How to judge? One way is to look for a credit rating. The two best-known ratings agencies, Moody's and Standard & Poor's, use slightly different gradings - generally, anything above 'BBB' (S&P) or 'Baa' (Moody's) rates as "investment grade".

However, not all fixed-interest investments are rated. In that case, you can get a rough guide to the risk you're taking by looking at the return; the higher it is, the riskier the investment.

The second danger, which applies only if you get out of the investment before the maturity date, is the risk that you may get more or less than you originally paid (see 'What if I get out early?', below)

What if I get out early?

Here's where things differ from other types of fixed-interest investments such as term deposits.

Debt investments of the type traded on the stock exchange can be bought and sold without any reference back to the original issuer. If that seems odd, remember that these are just promises to pay a certain amount of money in the future.

How much is such a promise worth? The answer depends largely on the return that competing investments are paying.

Imagine you own a fixed-interest investment, issued several years ago, paying a coupon rate of 8 per cent. By today's standards, that's high. Nowadays, another investor might be willing to pay you more than the face value to get those coupon payments. They'll lose money by paying more for the investment than they will get back when it matures, but the coupon payments will compensate for that.

On the other hand, if interest rates are rising, no one will want to buy an investment promising a relatively low coupon rate. Unless, that is, they can get it for less than the face value.

While the calculations can get complicated, the general rule is simple; falling interest rates make existing fixed-interest investments worth more, while rising rates reduce their value.

When you buy an existing fixed-interest investment, your return depends on two things - the coupon payments and the profit or loss you make on the face value.

The people who sell these investments take both those things into account and come up with something called the "yield". That's your total return from both sources and is the figure to use when comparing with other investments.

Any other questions?

As well as asking about yield and credit-worthiness, there are several other things you need to know before putting your money into a fixed-interest investment of this type.

Be sure you know what happens on the maturity date. With some investments you get back the face value, while others may convert into shares or offer the chance to re-invest for another term.

Think about the term you're investing for. Although you can sell these investments before their time is up, doing so may expose you to the chance of making a loss.

Ask how often the coupon payments are made. All other things being equal, the more frequent the better.

Be aware how much you'll need to invest. The minimum is often $10,000 or so. And be aware that some fixed-interest investments don't trade very often. If you buy an investment that falls into that category, and want to get out early, the fact that there are few potential buyers could be a problem.

For more information ...

Background information on fixed interest investments and a summary of trading activity can be found on the Stock Exchange website.

The Herald's share tables include a selection of these investments, under the heading "debt securities". For prospective investors, the important column is the one marked 'sell %', which is the yield that investment is offering. Many sharebrokers can also provide information on this market. For example, ABN AMRO Craigs website (click on "fixed interest") provides a daily rate sheet, as does the BNZ website.

* Contact Personal Finance Editor Mark Fryer at: Business Herald, PO Box 32, Auckland. Phone: (09) 373-6400 ext 8833. Fax: (09) 373-6423; e-mail: mark_fryer@herald.co.nz.