Put riskier returns in their place

By MARY HOLM

Q. Re borrowing at 6.1 per cent and investing at 8.28 per cent - interesting opinion from you in last week's column, in that you seem to be advising us to pay scant attention to 23 of the Herald's 24 investment adverts!

However, Mary, please don't resign on principle, as we always enjoy your words of wisdom.

On a more serious note, we would appreciate your comments on our approach to offerings with G6 ratings.

We're in our late 70s, with well over half a million in savings etc.

About 50 per cent is in Kiwi Bonds, 40 per cent is in the main banks, and 10 per cent is in G6-type investments.

Those include $50,000 in capital secured deposits with Capital & Merchant, covered by Lloyds of London Mortgage Indemnity and Mortgage Impairment Insurance Policies.

We two antiques hope you will advise us. Stay young!

A. I'm trying to. But then I get letters like yours that seem to imply that I should write with half an eye on the advertisers. That's enough to age any journo! Seriously, though - and not because of any pressure from anyone - I'm not dismissing investment in higher-interest products.

But they are considerably riskier than banks. Go in with eyes open.

For the benefit of those who don't know what a G6 rating is, Bondwatch is a service which rates finance company investments - from G1, safest, to G8, riskiest.

Of a G6 rating, Bondwatch says: "Ability to meet current obligations dependent upon favourable economic and/or business conditions. Concerns about security over the longer term."

I should add, though, that your Capital & Merchant capital secured deposits pay lower interest than the "investment deposits" discussed last week. So they are almost certainly somewhat safer.

Apart from your 10 per cent in these and similar investments, you have a very conservative portfolio, which is not inappropriate given your ages.

It's also quite appropriate to put a small portion of your savings into riskier investments, in pursuit of higher returns. If the whole 10 per cent turned to mush, you wouldn't be left in the gutter.

But you're taking unnecessary risk, by being badly undiversified.

Let's say your "well over half a million in savings" is $600,000 or $700,000, of which 10 per cent is $60,000 or $70,000. That means the $50,000 in Capital & Merchant is the bulk of your risky money.

As I said last week, I know little about the company. But I wouldn't put that much in any single company of that type.

Sure, the wording about Lloyds, insurance and so on sounds comforting. But I don't know what it means. Do you?

Too often, when things have gone wrong with similar investments in the past, words like that - along with "secured" and "guaranteed" - didn't amount to much.

I suggest that, when your current investments mature, you spread your money much wider, perhaps also looking into corporate bonds and capital notes. Read on.

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Q. We are both 62, have a comfortable freehold home and a $400,000 portfolio.

About 20 per cent is invested on short term or on call, 50 per cent in a beachside rental property and the remainder in fixed-interest financial bonds and debenture stocks.

We have split our investments for the latter into 11 parcels, including a recent split of $30,000 into $5000 lots over six financial institutions.

We have nothing invested for more than three years, and our average return is 8.33 per cent.

After many warnings from you and others in regards to "the higher the rate the higher the risk", we have become a little paranoid.

Your recommendation last week to try www.bondwatch.co.nz was most helpful and puts most of our investments in the G5 or what I believe is the medium-risk area.

The question I ask is: Despite the warnings we receive, could you tell me when was the last time one of these financial companies went down? And how many could you recall, say over the past 10 years, that have actually collapsed?

I cannot recall any recent failures, and wonder if the risk is as great as everyone says, especially if we stay with smaller parcels?

A. You didn't ask me, but I can't resist saying the following: If I were you, I would have some investments in shares or a share fund.

You're quite likely to live another 20 years or more, and they tend to bring in the highest returns over the long term.

Beyond that, though, I like your portfolio - assuming you need as much as $80,000 in short-term investments for rainy day purposes or because you plan to spend that money fairly soon. I particularly like the way you have spread your fixed interest investments. And an average return of 8.33 per cent suggests that you haven't chased really high returns, and therefore high risks.

Still, you're worried. And I must say that I, too, increasingly hear warnings.

For instance, in a recent article on www.goodreturns.co.nz, headlined "Red Lights Flashing", Philip Macalister writes that people from three finance industry companies all said at a recent conference "that some companies offering high-yielding investments such as debentures and mortgages are likely to fall over, and investors will lose money".

He quotes Neville Giles from the Hanover Group as saying it's not a matter of if, but when. "There is going to be a debenture issuer default."

Your response to such warnings, asking for examples, is fair enough. I'm afraid I don't know of a definitive list of failures. Does anyone else?

But I put the question to Cameron Watson of stockbrokers ABN Amro Craigs.

"The last time we had a decent bust-up in this sector was in the 1980s, when a raft of finance companies went under including the Investment Finance Corporation, Landbase, RSL and Development Finance Corp," he says.

"Soon after, the collapse of Skellerup and then Fortex also caught out many bond investors.

"It doesn't happen very often. But it doesn't need to happen very often if you are in the wrong one."

He says that a BBB bond rating from Standard & Poor's - the bottom of the "investment grade" ratings - "implies a 2.5 per cent risk that you will lose your capital".

"Most companies that offer debentures are not rated. Many would no doubt struggle to achieve an investment grade rating," adds Watson.

Where does this leave you? By my calculations, apart from your recent investments, you have five bond or debenture investments totalling $90,000.

If you lost your money in the largest of those, it would put a big hole in the higher-than-bank returns you've been making.

To reduce this risk, as your investments mature, you might want to diversify even more.

Still, there's a limit to diversification. Who wants to monitor scores of investments?

I suggest you spread your money until any one loss - or if you want to be really conservative, two losses - wouldn't be dire for you.

Of course there's always the possibility of more than two losses. But that's where paranoia creeps in. It's extremely unlikely.

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Q. Featured in a very prominent position in last Saturday's Weekend Herald was an advert for the Goodman Fielder Finance Capital Notes issue, providing a return of almost 10 per cent a year.

In these days of declining fixed interest rates this seems to me to be an offer that is too good to be true.

Goodman Fielder in my mind is far less risky than Capital & Merchant and similar companies offering 8 per cent or more.

Why does Goodman Fielder feel the need to better the per annum return by almost 2 per cent, when it would be seen as a less risky investment?

Should we be mortgaging the equity we have in our properties at 6.5 per cent and investing it in Goodman Fielder at 9.95 per cent? This again appears like money for jam.

A. And, again, looks can deceive.

First, note the difference in the terms of the issues you quote.

The 8.28 per cent paid by Capital & Merchant is on one-year deposits. The 9.95 per cent paid by Goodman Fielder is on eight-year notes.

In most circumstances, you are paid more if you tie up your money for longer.

If we compare like with like, Capital & Merchant pays 8.68 per cent on five-year deposits, whereas Goodman Fielder pays 9.75 per cent on five-year notes. That reduces the difference considerably.

Still, there's quite a gap. Why?

One partial explanation is that Goodman Fielder is trying to raise many times as much money as Capital & Merchant.

You would expect it to pay a somewhat higher rate just to attract the necessary volume.

Beyond that, let's consider risk. Just because we have all heard of Goodman Fielder - and the ads for the capital notes feature brands like Bluebird, Edmonds and Ernest Adams - that doesn't necessarily mean the capital notes are low-risk.

They are unsecured, subordinated debt.

When you get a mortgage, it is secured by your house. If you don't repay the debt, the lender can sell your house to get its money. With unsecured debt, there is no such backing.

And "subordinated" means that, if things go wrong, there are others in line who will be paid in full before capital note holders get a penny.

Just as there are warnings about debentures, so are there warnings about unsecured, subordinated capital notes.

Economist and portfolio manager Gareth Morgan writes on his website, www.garethmorgan.co.nz, about people buying these products.

"Slowly but surely we are seeing some of these investors manoeuvre themselves into a position where the risk they're exposing their capital to is soaring. There are going to be some casualties".

He goes on to say: "The day one of these issuers defaults and tells the investors to take a hike - as they're entitled to do to unsecured lenders - will be a sobering one for those who have invested indiscriminately in what is known in the trade as 'junk'."

For all that you think Goodman Fielder's interest rates are good, Morgan reckons they are too low.

"As part of financing the takeover of Goodman Fielder, Graham Hart's Burns Philp group has raised considerable dollops of debt. It has tapped the US and New Zealand markets.

"The irony is that for similar offerings - subordinated and unsecured - it has managed to get away with paying New Zealand investors way less than their US counterparts.

"The rate on the NZ paper is 9.75 per cent, whereas in the US it had to pay 10.75 per cent. Now is that crazy or what?

"If New Zealanders were to ascribe the same risk to this investment as Americans, then one might expect the company to have to offer 12.95 per cent for its offering here - some way from 9.75 per cent."

ABN Amro Craigs' Cameron Watson also places the Goodman Fielder notes at the higher-risk end of the spectrum. "The company has got a lot to prove, and it's got a lot of gearing," he says.

For all that, he tends to prefer publicly traded capital notes, such as the Goodman Fielder issue, over issues from companies like Capital & Merchant.

"The market prices its securities. The risk is more visible. The risk of a finance company is harder to assess."

It's also harder to get out of debentures early. Sometimes you have to pay a penalty. But capital notes can be traded on the New Zealand Exchange.

While Morgan thinks Goodman should pay higher interest, many say the same of small finance companies.

"If it's paying 8 per cent, perhaps it should be paying 18 or even 28 per cent," says Watson.

All in all, then, Goodman Fielder may be a better bet than Capital & Merchant.

Still, I reckon it's too risky to borrow and invest in. Instead of money for jam, you might end up with debt and junk.

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