Fixed Interest

It is likely that returns from bond markets this year will not match the levels achieved in 2002. Interest rates are already low and are not expected to fall significantly lower as the global economy and in particular the US starts to recover.

The Reserve Bank is operating under a slightly modified Policy Target Agreement (PTA), which like the old one focuses on keeping a stable level of prices within a band now defined as 1 to 3% over the medium term. The new bit is the inclusion of ‘medium term’ focus. This change will likely result in less interest rate volatility as it is now deemed more acceptable if the bank ocassionally goes outside the inflation band.

A low and more predictable cash rate will lead to an upward sloping yield curve (where short term rates are lower than long term rates) occurring most of the time.

Investors will not be rewarded by keeping their money on call or in 90-day bank deposits.

The search for yield will force investors to seek higher yielding corporate bonds, buy longer maturities or both.

We believe a neutral cash rate (a rate that will keep a non-inflationary growth rate of 3%) is around 6%. With less interest rate volatility expected with the PTA’s medium term focus we felt that over a business cycle cash rates in New Zealand will range between 4% and 7%. This interest rate range is much less than previously experienced and will be a helpful contribution to ensuring the economy does not experience the disruptive swings from boom to bust that has littered its economic past.

Retail interest in the corporate bond market increased markedly in 2002 and will likely be a feature this year. Not all bonds are created equal. Credit quality and the structure of bond issues will become increasingly important considerations before any purchase is contemplated.

With the collapse of confidence in global equity markets and some well-publicised corporate failures the investment public have entered into an age of conservative investing. In this age, investors will need to focus upon companies that:-

1. Provide a business plan or model that can be identified and understood.
2. have a strong and continuous operational cashflow.
3. have management and a board committed to sound business, accounting and governance practices.

The same common sense approach is needed if you are considering investing in debt or equity of a company. Investors globally have reduced their risk appetite. Interest rate margins have widened, especially in the US, with even the highest AAA rated companies are paying more for their borrowings.

Debt issued by lower rated companies has been even more harshly treated, however the widening of margins has not occurred to the same extent in New Zealand.

Corporates issuing debt into the NZ market have exploited the opportunity to raise low cost funds as retail investors have chased higher returns to make up for low nominal yields and negative returns from their international equity portfolios.

This retail demand and the lack of any major corporate failures in New Zealand has contributed to the lower corporate debt margins however corporate debt margins could widen if any adverse corporate event occurred. An example of this is the Tower Capital Bond. Initial issued at a yield of 8.75% the bond traded to in excess of 12% after a profit warning was issued. This represents a drop in capital value of approximately 12% if the bond was sold at the higher yield.

This is a timely reminder that risk and return cannot be separated.

Fergus McDonald is the head of bonds and currency at Guardian Trust Funds Management

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