Dissecting debentures

New Zealanders are very slow on the uptake when it comes to assessing risk and reward.

The demise of finance companies in 2007 and last year should have made many savers demand much higher returns for investing in higher risk debentures. It didn't and it still hasn't.

The rushed introduction of the retail deposit guarantee scheme last October may have confused some investors and reassured them for terms up to October next year. But even then, debentures maturing after that date should have offered much higher interest rates.

This week's announcement of an extension of the deposit guarantee until the end of 2011 is good news for those who assumed an extension, but savers should be careful about the scheme's changed terms.

Only deposit takers with credit ratings of BB and better can apply for the scheme's protection and then they must pay a hefty fee for the privilege.

Take, for example, Allied Nationwide. It is offering 7 per cent for a two-year debenture and 7.5 per cent for three-, four- and five-year debentures.

Allied Nationwide does not have a credit rating and should therefore be classed as sub-investment grade or "junk". It may well get a BB credit rating, but it doesn't have one yet and should be priced accordingly.

Allied Nationwide's two-year rate of 7 per cent should have been increased substantially once it was clear the scheme was being extended with conditions.

The three-, four- and five-year rates of 7.5 per cent make no sense at all. They are scheduled to mature after the deposit guarantee expires and should therefore be priced as a very speculative investment.

New Zealanders seem unable to understand or price the risks involved with speculative debenture investments.

The Reserve Bank is doing its best to change the language of this type of investment by forcing all bank and non-bank deposit takers to get a credit rating.

In future years these should be the first questions any saver asks: what is the credit rating and is it in the retail deposit guarantee scheme? If it is not in the scheme and does not have a credit rating of BB or better it should be regarded as speculative.

That's when savers should demand an aggressively higher interest rate.

In the United States, investors are more used to investing in speculative or "junk" investments. Currently, these bonds offer around 9 per cent over the safest type of bonds, such as US Treasuries.

A three-year junk bond is therefore currently trading at around 11 per cent, which is around 9 per cent above the safest bonds there.

Given our safest three-year government bonds are trading at around 4.5 per cent, a margin of 9 per cent should take the total offered to at least 13.5 per cent. Yet most finance companies in this category are still only offering around 7 per cent to 8 per cent. Why are New Zealanders accepting this?

It is possible no one is accepting it and the rates being offered are simply for show. But some are collecting significant sums for periods of longer than two years.

Part of the problem is that many finance companies don't want to advertise their speculativeness by charging a high rate.

The great irony is that for years finance companies have pulled in more money by offering low rates that reassure investors they are safe.

New Zealand savers need to stop attributing safety to the rates being offered and look at the underlying security of the debenture, its credit rating and its track record.

It means doing a bit of work, but it is more rewarding and safer in the long run.

Meanwhile, finance companies offering debentures for longer than two years simply need to put up their interest rates.