Money: From Capital, with interest

Income tax, provisional tax, withholding tax, GST - the traffic between our wallets and Wellington seems to be all one way.

But there is a way to reverse the flow and get the Government to pay your bills. How? By investing in Government Bonds.

They may be as dull as a bureaucrat's suit, but don't write them off on that account.

Consider yourself a candidate for Government Bonds if you need regular income with the best-possible security, are looking for something long-term, or just like the idea of diversifying.

Count yourself out if you want the highest interest rates, are aiming for long-term growth - which you are more likely to find on the sharemarket - or like your investments exciting.

Government Bonds, also known as Government Stock, are a fixed-interest investment but they work differently from the term deposits you will get from a bank or finance company.

Think of them as a promise - a promise to repay a set amount, known as the face value, at a set date and to make interest payments in the meantime.

Governments satisfy their thirst for cash by selling those promises to investors.

Most of us don't have the sort of money you need to lend directly to the Government. Our opportunity comes when the big players break those promises into smaller units and offer them for sale.

The way that sale process works is what makes bonds different from term deposits.

Typically, the smallest Government Bond you will be able to buy will have a face value of $10,000. But it's highly unlikely that you will have to front up with exactly $10,000. It could be less or - more likely these days - more.

To understand why, remember that the interest payments are fixed when the Government issues a bond, as is the final repayment.

But if a Government issued bonds paying 8 per cent, for example, and rates available elsewhere then increased to 12 per cent, no one would want to buy the bonds from the original investors.

If rates elsewhere fell to 6 per cent, on the other hand, those 8 per cent bonds would look like a goldmine and no one would want to part with them.

Something has to give, and that something is the initial purchase price, which changes in order to keep the return on a bond in line with returns on other investments.

If you buy a $10,000 bond paying 8 per cent, you will receive $800 a year. But that's only an 8 per cent return if you paid $10,000 in the first place. Pay more and you're effectively getting a lower percentage return, less and the $800 represents more than 8 per cent.

If you pay less than face value, you will also get a capital gain when the bond matures and you receive the full $10,000. If you pay more than face value, the return from the interest payments is reduced by a capital loss.

The maths can get daunting but there's no need to grapple with the calculations yourself. The people who sell Government Bonds do the numbers for you and wrap the result into one figure, known as the yield.

Yield is your total return - interest payments plus or minus any capital gain or loss. Think of it as the rate you would have to earn on a standard fixed-interest investment to produce the same total return.

Those yields are subject to constant change but, as a rough guide, Government Bonds are currently yielding 6 to 6.7 per cent, compared with a maximum of about 7.2 per cent on bank term deposits.

Like any fixed-interest investment, after you knock off tax (which is charged on the total return, including any capital gain) and inflation, Government Bonds are a way of preserving your money's value, and perhaps earning a very modest return, rather than a route to riches.

But they do have the virtue of being the most secure investment in this country.

They are also available for long terms. If you want, you can lock your money up until November 2011, earning a yield of about 6.7 per cent until then.

There is an active trade in Government Bonds so, if you want to break your investment before it matures, you should have no trouble finding a buyer.

If you do sell before the maturity date, you have to take whatever price the market sets - if interest rates have fallen since you invested, you may make a (taxable) capital gain when you sell.

If rates have risen, your bond will be less desirable and you may suffer a (tax-deductible) loss.

However, that risk applies only if you sell before the maturity date.

But even a buy-and-hold strategy is not entirely risk-free. A 6.7 per cent yield on an 11-year bond may not look like a bad deal now, but it might not seem such an attractive proposition if inflation and interest rates rise. Not only will inflation be eating into your money's value, you will also be missing the chance to earn more interest elsewhere.

On the other hand, if interest rates fall after you invest, you will feel very smug.

If bond investments appeal, there are options beyond the Government. State-owned enterprises, local authorities and companies also raise money the same way.

The principles are the same but the security is not as rock-solid (though it can be very close in some cases) and yields tend to be higher as a result.

The Government also offers Kiwi Bonds, aimed at smaller investors and available through sources such as banks, brokers, solicitors, accountants and financial advisers, or direct from the Reserve Bank (0800 655-494).

Kiwi Bonds are paying 5.75 per cent on investments of $1000 to $4900 for terms of 6 months to 4 years. Investments of $5000-plus earn 6.25 per cent for the same terms.

Despite the name, these are more like an everyday term deposit - you pay your money, receive the promised interest payments and get back your initial investment at the end. Unlike "real" Government Bonds, there is no market for Kiwi Bonds and you will suffer an interest rate penalty if you get out early.

At least one source now offers Government Bonds over the internet. The BNZ's Bond Direct service (www.bnzist.co.nz) allows users to buy and sell a variety of bonds but you will need to register as a user before you can see what's on offer.

*To contact Weekend Money editor Mark Fryer, write to: Weekend Business, PO Box 32, Auckland. Ph: (09) 373-6400 ext 8833; Fax: (09) 373-6423; e-mail: markfryer@herald.co.nz