KEY POINTS:
Q. We have down-sized from a large family home in the central Auckland suburbs and, while it is nice to have no mortgage payments and close to $400,000 sitting in a Raboplus account, we have found that we really do need a larger home for our sanity.
We have three kids aged six to 10, and we have to be strategic about what secondary school areas in central Auckland we wish to be in.
We are both simple wage earners. We have a favourable revolving credit facility, no actual table mortgage to pay at all over our $900,000 home, and use the revolving overdraft for small excess living indulgences with the kids and some improvements to the small home.
We are torn between using the funds and equity and borrowing a bit more to upsize into a good secondary school area before we can't afford to, or taking advantage of buying a niche coastal property in a special area as a strong bet for major capital gain, which we might capitalise on when our younger kids get to secondary school age.
That would give us the freedom of sending them to private schools and not having to be as concerned about which central Auckland area we are in.
A. Your choice of the word "bet" on the coastal property may be more apt than you realise. I strongly suggest you get back into a larger home in the right area, rather than gambling on the coastal property market.
I know, I know - the values of many coastal properties have soared in recent years and many people feel you can't go wrong with a house near a beach.
But that's not true. The housing market is looking shakier now than it has in years. And when any boom turns to a bust - whether it be shares, property or tulip bulbs - the most vulnerable assets are often those that rose furthest in the boom.
There's also the bach factor. I'm not predicting an economic downturn - that's not my area of expertise - but some experts are and, if times get tough, people are more likely to sell their baches than their homes, which has a depressing effect on the value of all coastal property.
Sure, over the long term you would probably do fine with a place by the sea - might do very well indeed - but it sounds as if you'll want to sell up for the children's schooling in just five to 10 years. I would say there's too big a chance you won't make much on a coastal property over such a period and could even lose money, especially after allowing for buying and selling costs.
Why take the risk, when instead you could be sure you're okay? If you're in a suitable house for the family over the next 15 years or so, you won't need to worry about what happens to house prices.
By the way, at the risk of being a killjoy, I didn't like reading that you are adding to your mortgage for small indulgences. You're probably paying around 10 per cent interest for the privilege. Borrowing to buy anything that falls in value is no way to get ahead financially.
On the other hand, your other use of the money - making home improvements - can be an excellent investment if the changes add more value to the house than they cost, including mortgage interest.
It's a sign of the times when two "simple wage earners" downsize into a home costing $900,000.
Q. In your book KiwiSaver: How to make it work for you, you show a "Winners and Losers" table of the various forms of investment. New Zealand bonds show great volatility, varying from 0.1 per cent to 7.4 per cent.
This is because fund managers, when they value their bonds each year, have to "mark to market". Under this valuation method, when bond yields rise, their capital value falls. Conversely, when yields fall the capital value rises.
This means that those entering conservative funds under the KiwiSaver scheme, with lots of bonds in them, run the risk of striking a time when interest rates are high and bond values are low when they retire from the scheme at 65.
A conservative fund can thus mean quite the opposite to its intention in that it may be a gamble on the state of the market for bonds in some decades' time.
Individuals investing directly in bonds do not suffer these upheavals if they hold the bonds to maturity, as most of us do.
Quite apart from KiwiSaver, the message is that to be truly conservative, individuals should invest directly in bonds, rather than through an intermediary such as a unit trust.
A. I wouldn't say a range of 0.1 per cent to 7.4 per cent is "great" volatility. Overseas shares in the same table - which shows returns from 1996 to 2006 - range from minus 36.9 per cent to plus 40.1 per cent. That's great volatility.
Still, you raise an interesting point, although there are ways around the problem.
First, some explanation for others about marking to market, which is putting today's market value on the fund's holdings.
Bonds are rather like term deposits. You might pay $10,000 to buy a five-year bond, receive regular interest payments and then get your $10,000 back after five years. The big difference from term deposits is you can sell the bond in the meantime.
A fund that holds bonds will include some bought some time ago and some bought more recently. If interest rates have risen, the bonds bought earlier will now have below-market rates. Therefore, if the fund sold them, those bonds wouldn't be worth as much as when they were purchased.
For example: a while back, a fund bought a $10,000 bond paying 8 per cent or $800 a year. Market interest rates have since risen to 10 per cent so the bond, at face value, is not as attractive as recently issued alternatives. However, a buyer might be happy to pay $9000 for the bond. The $800 interest would then amount to 8.9 per cent on $9000, plus the buyer would get back $10,000 - an extra $1000 - at maturity.
Conclusion: When interest rates rise, the value of bonds issued earlier falls.
What if, instead, interest rates fell, from 8 per cent to 6 per cent? Our $10,000 bond paying $800 a year would be very attractive. A buyer might be willing to pay $11,000 for that bond. The $800 interest would amount to 7.3 per cent on $11,000. That's well above the 6 per cent market rate, which would compensate the buyer for the fact that she or he will get back only $10,000 on maturity.
Conclusion: When interest rates fall, the value of bonds issued earlier rises.
In the table in my book, the year in which bond fund returns were 0.1 per cent was no doubt a year when interest rates rose, so the value of older bonds fell. This would have dragged down the total return on bond funds, even though they would have received well over 0.1 per cent in interest payments.
All of this makes bond funds seem more volatile than if you simply buy your own bonds and hold them to maturity. During your holding period, the market value of your bonds would probably wobble all over the place, but it doesn't matter if you don't sell. In our example above, you would simply get your $800 interest each year and $10,000 back at maturity. What's more, you wouldn't have to pay any fund management fees.
For these two reasons, directly holding a range of good-quality corporate bonds makes lots of sense. Unless you have considerable savings, it's much easier to diversify in a fund, which holds many bonds.
Also, I note that you say, "Quite apart from KiwiSaver". But what happens if we add KiwiSaver to the mix?
If you want to invest in bonds via KiwiSaver, you'll have to do it through a fund. And you are almost always going to be better off in a KiwiSaver bond fund than with direct bond holdings. The KiwiSaver incentives - the $1000 kick-start, tax credits and, in some cases, employer contributions - make KiwiSaver investments grow much faster than most alternatives.
So how to address the problem of striking a bad period in the bond market at retirement? Spread things out over time, in one of two ways:
* As you approach retirement, you could gradually move your money from a bond fund, or a conservative fund that holds mainly bonds, into a cash fund. You might start five years before retirement and transfer 20 per cent a year.
A cash fund invests in the likes of short-term government bonds and bank term deposits, and the value of those investments will barely fluctuate at all.
If your provider doesn't have a cash fund, or won't go along with your moving money this way, you can switch at any time to a provider who will.
* In retirement, don't take out all your money at once. You can keep your KiwiSaver account going for as long as you like. True, once you've reached the age at which you can withdraw money, you will no longer receive tax credits or compulsory employer contributions. But it will still probably be a good place to invest your savings until you plan to spend them.
If you withdraw the money bit by bit in retirement, sometimes you will strike bad times in terms of bond values and sometimes good times. As long as people use one of these spreading strategies, they won't face the problem you present.
Quick KiwiSaver info
For easily digested information on the rules and incentives of KiwiSaver, see the KiwiSaver book page on www.maryholm.com
* Mary Holm is a seminar presenter, author and publisher. Her website is www.maryholm.com. Her advice is of a general nature and she is not responsible for any loss that any reader may suffer from following it. Send questions to mary@maryholm.com or Money Column, Business Herald, PO Box 32, Auckland. Letters should not exceed 200 words. Please provide a phone number. Sorry, but Mary cannot answer all questions, correspond directly with readers or give financial advice.
