When down means up

By MARK FRYER

You may not have noticed, but a bull market has been rewarding investors with some outstanding returns for quite a while now.

No, not the sharemarket, even if it has rebounded in the past few months, both overseas and in New Zealand.

And no, it's not the surging property market.

This is the market that doesn't get all the publicity. It's the market for fixed interest investments such as Government stock and corporate bonds.

While it tends to be ignored by those of us who aren't professional investors, this market has been running hot.

In New Zealand, investments in Government stock returned 12 per cent in the 12 months to the end of May. Internationally, Government bonds returned almost 24 per cent (measured in US dollars) in the same period.

These are phenomenal returns on an investment that is usually thought of - if it gets thought of at all - as safe but dull.

Fascinating, but what does it mean to ordinary investors?

Quite a bit. Whether they know it or not, many investors have some of their money in the fixed interest markets.

That includes virtually anyone saving through a superannuation scheme. Or anyone who has their money in a managed investment that describes itself as "diversified" or "balanced" or "conservative". Or in a specialised fixed interest fund.

In the year to March, the average fund manager made 11 per cent on their New Zealand fixed interest investments and 12 per cent on similar investments overseas - at a time when their shareholdings were going in the opposite direction - according to figures from Aon Consulting

The average NZ fixed interest unit trust or group investment fund earned its investors 6.9 per cent in the year to the end of May, according to figures from researcher FundSource - not spectacular, but not bad either, especially given that those returns are after tax and fees.

Fixed interest funds which invest internationally did even better - up 8.3 per cent in the same period, after tax and fees.

Why all the gains?

Because interest rates have been falling, and when rates fall, the value of fixed interest investments such as Government stock goes up (for more on this apparently back to front relationship, see "When falling rates...", right).

That means a capital gain for anyone holding those investments, on top of the interest payments they also produce.

The push for lower rates has been led by central banks in many countries, which hope that if the cost of borrowing money goes low enough, businesses and consumers will be encouraged to spend more, encouraging an economic revival.

Leading the charge has been the United States. Its central bank, the Federal Reserve, has been cutting interest rates for the past 2 1/2 years and did it again this week, pushing US rates down to levels not seen since 1958. Other central banks have also been busy cutting rates.

None of this may be much of an issue for anyone who invested in Government stock simply to receive an ultra-secure income, who doesn't much care what their investment is worth on the market - although it will be an issue when the investment matures and they have to find another source of interest income.

But day-to-day movements in the market matter very much to people such as fund managers, who are obliged to revalue their investments regularly, and pass those revaluations on to their investors.

The big question now is whether fixed interest has room to deliver further gains, or whether the good news is over.

The answer depends largely on economic growth. If there is an economic rebound, especially in the US, interest rates could rise and investors could suffer capital losses rather than the capital gains of the past.

But if economies don't come back to life, rates could go even lower and investors could be rewarded with even more gains.

Which way will it be?

"You'd have to say there are as many views about that as there are fund managers," says Anthony Quirk, managing director of Guardian Trust Funds Management.

While he doesn't believe bond investors are suddenly about to see the value of their investments fall, he does believe they have to accept lower returns over the year ahead than they have become used to.

"It's not a case of having to panic about bonds by any means ... what does disturb me a little bit is that we've seen some investors get out of equities, sometimes near the bottom, and get into bonds thinking they're a safe haven."

Even Government bonds are not risk-free. While a Government guarantees the interest payments, the market value of the investment can still fall.

That's not just a theoretical possibility; rising interest rates meant New Zealand bond investors lost money in 1994.

As Paul Dyer, chief investment officer with AMP Henderson Global Investors, points out, the benefits of falling interest rates must eventually come to an end. "We've had capital returns as yields come down and down and down, and that mathematically just cannot continue."

"Do we think that fixed interest is a particularly good investment at the moment - the answer is clearly no," he says.

However, investors in New Zealand Government stock can take some comfort from the fact that yields in this country are among the highest offered by any government investment in the world, and it's likely that the Reserve Bank will cut rates further.

Mark Brighouse, chief investment officer at Arcus Investment Management, says he has "real concerns about global fixed income".

"I know a lot of other people in the industry in New Zealand have said fairly favourable things about them [international fixed interest investments] and we're probably of the opposite view in terms of warning people about, first, expecting the capital gains that they've had in bond markets to be repeated - and it's been a sensational decade for bonds. Mathematically that can't be repeated. And secondly, warning them that there is a lot of risk in there."

Even though New Zealand interest rates have not fallen as dramatically as they have overseas, he points out, it would be unlikely that this country could escape an overseas "correction" in the fixed interest market - meaning the end of the bull market and falling values for investors.

* To contact Personal Finance Editor write to: Weekend Herald, PO Box 32, Auckland. Email Mark Fryer. Ph: (09) 373-6400 ext 8833. Fax: (09) 373-6423.