Traps for fixed-interest investors

By FIONA JUDD*

New Zealanders share some common misunderstandings regarding investing in fixed interest. The sad irony is that the thing they are trying to avoid - risk to their capital - is the very thing to which they end up exposing themselves.

Many New Zealanders are familiar only with investing their money in bank term deposits. They remember when inflation was high and they received double-digit returns on their term deposits. If they relied on income from these investments for their livelihood, then life seemed rosy.

Incidentally, this golden time was a mirage because, after tax and inflation, term deposits were going backwards. The classic example of this was farmers who retired in the mid-70s, put their money in the bank and starting finding employment again in the 80s because their purchasing power had diminished spectacularly.

Now we live in the opposite situation. Low inflation protects the buying capacity of your term deposit but low interest rates do not produce a lot of income for people to live on.

Hence your traditional, fixed-interest investors are scouting around for better rates on investments. A mixture of naivety and greed drives many to the offerings of debentures, capital notes, mortgage funds and contributory mortgages. Unfortunately all these investments advertise by offering returns quoted as interest rates and investors appear to simply choose the biggest return on offer without regard to the reason this return is on offer.

But I very strongly question whether risk-averse, income-requiring investors should go anywhere near double-digit fixed-interest return investments in this current environment.

Most New Zealanders facing retirement and new to the practice of requiring investments to fund their retirement often adopt a mindset that says: "I like investments which pay a declared rate of return because that is like a term deposit, which I understand. I am sure that the promise of regular income means this investment will keep my capital safe and now I just need to get the highest percentage I can find."

Typically these clients will be wary of other investments, such as shares, because they interpret the uncertainty regarding their annual return as meaning that their capital is at greater risk.

However, let's look at some of these offerings of high interest. Generally double-digit, fixed-interest return investments are offered by organisations wishing to raise money to finance property development projects. These are usually single subdivision projects in which the developer provides a plan for development and a valuer's appraisal of the finished valuation of the project.

Guarantees are provided by the developer and investors imagine that it is a simple case of build them, sell them and repay my capital and interest to me - the developer must know what he is doing because he is offering his assets to repay me if something goes wrong.

A fellow financial planner told me of an investigation on a proposed investment he carried out for a client. The investment, offering an 11 per cent return, was to develop property in a resort town.

Investigations revealed that behind the architect's glossy drawings was a less than attractive site, the valuation of the finished project was extremely optimistic and it appears the developer's assets, offered as an unlimited guarantee, was a $150,000 family home with its mortgage status unknown.

This brings home the reality that to be offered such returns, the investor really is the lender of last resort.

In fact, it can be argued that with a realistic appraisal of risk, the rate on offer, far from being generous, is an insult.

It is curious that if we substituted a business instead of the property development and offered a share of the profits instead of a declared rate of return, investors would likely say this was very risky. And yet their fixed-interest investment is offering the same type of risk.

The solution lies in the fundamentals of diversification, where a spread of asset types is used because every asset has a purpose.

Fixed interest is supposed to be a safe, pedestrian investment. If you want higher returns then you do not change fixed interest, you increase your exposure to shares where you should be appropriately compensated by higher returns for greater risk.

I return to the sad irony that investors choose risky fixed-interest imagining they are avoiding a higher risk from other investment types. The reality is they take on far more risk unwittingly for poor compensation and jeopardise their capital.

If you forgive the mixing of metaphors, fixed interest is meant to be a duck. Try to make it into a swan and you will likely end up with a turkey.

* Fiona Judd, of Broadbase Financial Services, was named financial planner of the year for 2002.