Sharebroker puts money on bonds and takes stock of the options

By BRENT SHEATHER*

Anyone with any sense of history knows that if it is maximum return you are after, shares have been a better investment than bonds.

The graph compares the performance of US Government bonds and US shares since 1926. It is no contest - shares have returned 11.2 per cent a year, while bond investors received 5.3 per cent.

But the financial markets are full of surprises and it seems that as soon as a particularly profitable trend is widely identified and all and sundry pile into it, the trend reverses.

This happened spectacularly a few years back when a couple of British academics widely published a paper showing that small firms had outperformed large capitalisation stocks by 3 per cent a year or so since the 1920s.

No sooner was the ink dry on the paper than small stocks dived and large capitalisation stocks outperformed them for about five years.

And it seems whenever the masses get excited about some sector of the global equity markets - as with Asia a while back and Europe and Japan more recently - these markets are bound to subsequently underperform.

Bonds have performed below shares for about 100 years and just about everyone owns stocks. So the contrarian in me thinks it's time to buy bonds.

While globally shares have beaten bonds over the long term, it has been a close-run race in 2000. In the eight months to August 30, the JPM Morgan global Government bond index was at 19 per cent, just ahead of the MSCI world share index at 18.7 per cent.

But in New Zealand it is no contest. Government bonds at 6 per cent are well in front of the local sharemarket, which has gone backwards by 2.4 per cent. And New Zealand has the dubious honour of being one of the few developed nations where the lower-risk Government stock's 10-year return at 9.7 per cent a year is better than that of the stockmarket at 9.6 per cent.

If we are going to see a resurgence in bond investing, it might be a good idea to look at the nature of the fixed-interest markets in NZ and a strategy for getting a good deal.

There are two ways of investing in bonds - directly, by buying the bond yourself, and indirectly by buying units in a managed fund. The first thing to remember about direct fixed-interest investing is there are two markets, each with different characteristics:

The primary market is where investors buy directly from the institution borrowing the money. Examples are a term deposit from a bank, a debenture from a finance house, or capital notes from a NZ corporate.

The secondary market is where debt is traded by banks and other professional investors. Intermediaries such as stockbrokers, merchant banks and financial planners buy bonds on this market, take a margin and sell them on to smaller investors.

One must play to one's strengths when investing, so if you are confident that you can assess each debt instrument's risk-and-return profile you may be able to sift the good from the bad in the primary market.

But the odds are heavily stacked against you. For one thing, the intermediary trying to flog the new issue will not have a clue about the creditworthiness of the issuer, probably has not read the prospectus and, in all likelihood, will be recommending ABC company's capital notes only because they pay twice as much commission as the alternatives.

And the fact there is a primary offering of ABC's debt will be either because it is a less costly method of financing than borrowing from a bank or, if you are really unlucky, because the banks will not lend it the money at any price.

Too many retail investors look only at the interest rate and hope for the best. The primary market for debt is an accident waiting to happen for the inexperienced unless you play safe and stick to institutions such as banks.

The primary market for debt does not always price risk as effectively as the equity market because in many cases the market in an issue is so small it warrants no interest from professional investors. If you want to market a $5 million to $20 million issue you do not even need institutional support.

For my money, the secondary market is a better bet, if only because there are no big commissions reducing returns and influencing judgments. Sadly, though, most institutional business is done in the largest, most liquid instruments - which in NZ means the Government and SOE bond issues.

In contrast, the secondary markets in capital notes, debentures and the like are characterised by low volumes and wide spreads.

The importance of liquidity should not be underestimated. As in the equity markets, liquidity gives intermediaries a reason to research an instrument. There is no point in doing extensive analysis of an institution's debt if its capitalisation is minimal.

Thus there is a great deal of safety with institutions, as their hundreds of millions in debt on issue will be subject to scrutiny by rating agencies and institutional investors.

So the best strategy for direct investors is to buy on the secondary market a liquid, A-rated issue that you can be confident effectively prices the risk of the issuer.

Benchmark the yield against what a selection of banks will give you for the same term. This strategy means you can be confident of the return on your capital and the return of your capital.

Although the yield you receive will be a per cent or so less than riskier issues might give you, it is frequently better than what the banks offer, particularly for maturities of three years and more. Furthermore, the bond market gives you liquidity, so you can sell out if you need to. And there is no penalty - just the risk that prices have changed. The market also allows you to manage the maturity profile of your portfolio.

Other advantages of liquid instruments like Government and SOE bonds are that the market is less volatile, has narrower spreads and transaction costs are often lower, too.

Investing in domestic bonds via a managed fund presents an entirely different set of issues for the private investor.

Bond unit trusts are frequently marketed with the assumption that the fund manager is able to determine the outlook for interest rates and will adopt a suitable strategy.

But long-term research in the US points to the inability of fund managers to consistently beat the relevant bond index over the longer term. The large, liquid bond markets are as efficient as equity markets.

However, costs as a percentage of total returns are far higher, making the added value/extra cost trade-off that much more difficult.



The investment editor of the London Financial Times recently commented on bond fund costs: "It is impossible for bond funds to bear anything like the level of charges which have come to be imposed on equity funds in recent years ... investors must focus on much more humdrum management styles which rely on efficiency and low costs to gain an edge."

Could she have been thinking of a buy-and-hold strategy via the secondary market perhaps ... ?

*Brent Sheather is a sharebroker in Whakatane.