Low risk, not no risk

By BRENT SHEATHER

With shares off the menu for many investors, more and more advisers and stockbrokers are focusing on fixed-interest products as a low-risk alternative for their clients.

Unfortunately, financial advisers' views of what constitute "low-risk" bonds vary widely.

Once we could say with some certainty that shares were more risky than property, which was in turn more risky than bonds. But in today's market some bonds are riskier than some shares.

This is compounded by the tendency of advisers to always diversify a share portfolio by buying shares in a wide range of companies, but often leaving the bond component concentrated in just two or three bonds.

Thus, investors switching from the perils of the stockmarket to the security of bonds may unwittingly be jumping out of the frying pan into the fire.

An example of one extreme view of what constitutes a low-risk fixed-interest portfolio crossed my desk recently.

A trust had $1.1 million to invest. The adviser, after meeting the trustees, assessed the trust's risk profile as "conservative and defensive", explained in a note that "the key to prudent investment management is the management of risk" and attached information on modern portfolio theory.

Great stuff, but there was no discussion of credit risk, interest-rate risk, liquidity or the fees to be incurred either by the trust or payable to the adviser.

The financial plan recommended three finance company debentures and two capital notes: Tranz Rail and Brierley, the latter incorrectly described as being of "investment grade".

The financial planner's proposal is interesting because it neatly encapsulates many of the mistakes commonly made by fixed-interest investors when they focus on the return on an investment and forget about the risk.

While the adviser attached information on modern portfolio theory (MPT), it doesn't appear that he has read it.

One of MPT's major conclusions is that one should invest in the various investments available in proportion to their size - more money in Government stock, less in bonds issued by small companies, for example. In contrast, the proposal would see the trust investing about 80 per cent of its assets in non-investment-grade bonds issued by small companies, which collectively represent a tiny fraction of the local fixed-interest market.

The plan invites the trustees to lend a good part of the trust's assets to entities whose clients, in the main, are companies or individuals the banks will not lend to, with a concentration on New Zealand property development loans and in only one currency, the kiwi dollar.

Prudent? Conservative and defensive? I don't think so. Less than half of the proposed portfolio is rated by leading rating agencies like Standard & Poor's or Moody's.

This doesn't necessarily make it high risk, but it certainly is not a good sign.

Fixed-interest offerings which are below investment grade - otherwise known as junk bonds - are a legitimate investment. But for mums and dads they only make sense on a small scale - say, up to 10 per cent of the fixed-interest portfolio, and only when held via a fund which can diversify over 50 or more issues.

Overseas, junk debt is really out of favour at the moment, thanks to worries about the sustainability of economic growth and corporate profits.

While the golden rule of diversification is almost always applied to shares, it is frequently forgotten in the fixed-interest area.

The financial planner is proposing to invest 20 per cent of the trust's assets in two relatively small companies listed on the New Zealand Stock Exchange. The same adviser would probably throw up his hands in horror at the thought of concentrating 20 per cent of the trust's assets in the ordinary shares of these companies, yet apparently ignores this risk when investing in their capital notes.

You can bet that none of the banks which lend money to Brierley and Tranz Rail would have more than 2 or 3 per cent of all their loans with those companies, yet this trust will have 20 per cent of its assets invested in the more risky capital notes.

So much for Tranz Rail and Brierley, which are at least listed on the sharemarket and have institutional shareholders and long-term track records (admittedly, not good ones).

The finance company debentures are in another league of risk completely. One of the fundamentals of prudent banking practice is to diversify one's loans across various industries, yet the proposal will see the trust having about 80 per cent of its assets lent to companies exposed to New Zealand property developments.

This is particularly significant as one of the trustees' key requests to the financial planner was to diversify the trust's investments.

Property development finance is high risk; this country has an unenviable history of property development company failures.

There are also structural problems with the debenture market; in this country the secondary market for these things - where existing debentures are bought and sold - is often non-existent.

That means there is little in the way of independent price setting. Prices are set by the issuer, usually having regard to the yields offered by similar organisations. With more liquid debt investments, such as those issued by the Government and state-owned enterprises, an active secondary market with institutional buyers and sellers sets a benchmark for new issues.

And because there is little trading, there is no incentive for brokers or intermediaries to research the outlook and risk of each company.

Similarly, the secondary market in smaller company corporate bonds is often sparse, with little, if any, institutional involvement.

Retail investors invariably end up with this or that capital note because they happened to walk into a stockbroker or financial planner's office on the day they had some of that issue to sell (often because it is an investment banking client), not because they make any particular sense from a portfolio perspective.

Better to trust the share and property markets as effective arbiters of risk rather than these illiquid debentures and corporate bonds. Poor liquidity means it may also be difficult for the trust to get out of the proposed investments, particularly in a recession.

A further consideration is that the rationale for owning bonds is to provide stability and a certain income in bad times.

High-grade bonds and shares have been negatively correlated in the last couple of years; when one is down the other goes up. No so with junk debt. Smaller companies and the finance companies like those recommended are more likely to go bust in times of recession.

In times of market stress, like those the overseas markets appear to be in now, higher-risk bonds change their spots and start acting like shares, falling in value even as lower-risk bonds rise in value. This occurs because investors worry that the impending difficult times will result in risky companies defaulting on their debt.

Higher-yield bonds thus offer little diversification and are a bit like umbrellas that you can use only when it is not raining.

In contrast, state-owned enterprise bonds have the advantage of having an owner (the Government) who can print more money to pay the interest bills if times get tough.

So what do professional investors' portfolios look like? This should have been of interest to the trustees in this case because the courts have ruled that where trustees invest they must be prudent.

Various cases have defined "prudent" as being a lot like what the experts do. What they don't do is put much, if any, money into small finance companies.

I looked at four leading fixed-interest unit trusts and found they have an average of less than 2 per cent of their assets in non-investment-grade bonds and no money in small finance companies.

At the other end of the spectrum, the trust has none of its assets in investment grade bonds.

One fund manager who asked not to be named said professional investors frequently had minimal exposure to small, local, unlisted finance company debentures because of their high default risk and lack of liquidity.

What would happen to a fund manager who informed his boss that his portfolio looked like the charitable trust described above? He or she would be out of a job pronto and unlikely to work in the industry again.

Trustees need to exercise as much care as a professional fund manager, as the courts have found on various occasions, and no doubt will again as mistakes made in the recently ended bull market slowly rise to the surface.

* Brent Sheather is a Whakatane investment adviser.