Safe parking?

Sounds reasonable, except when they choose this asset class, they still focus on the ‘yield’ (the expected return) and ignore the effect on risk.

There is a strong risk/reward trade-off in such decisions – after all there is no upside as the best result is that you receive regular interest payments (coupons) and get your money back on maturity. Hence, investors need to be very aware of the risks they are really taking if they want to avoid compromising what they perceive as their ‘safe’ investment.

The risks
While there are a range of ‘risks’ that affect fixed interest investments, the most obvious and most material in respect of the returns are ‘duration’, ‘liquidity’ and ‘credit’ risk.

Interest rate or ‘duration’ risk
All interest rate investments with a future maturity have a ‘duration’ risk. This is simply a measure of the price sensitivity of your bond/fund to changes in interest rates.

As a general rule of thumb, the price or present value of a bond with a ‘duration’ of five (e.g. five years) would alter around 5% for every 1% change in yield or interest rates. Similarly one with a duration of three would alter around 3% for every 1% yield change.

For example, if a bond has a fixed maturity value of $100 and pays annual credit interest of $10 (10%, the coupon) and you buy it at a yield (the current market interest rate used to discount the expected cashflows being coupon + maturity value) of 10% it will cost you $100.

But if interest rates then rise to 11%, you don’t get a replacement bond with an 11% coupon. Instead the change in yield/interest rates has to be compensated for in the price you buy or sell the bond.

The bond with a ‘duration’ of five would now be worth $95. It is still paying a $10 coupon and returning $100 at maturity but by paying $95*, instead of $100, you now get a return of 11% on your new $95 investment. (In this example, if interest rates had fallen to 9% the price of the bond would have risen to $105.)

If you don’t need to sell your bond you can hold your 10% bond to maturity and continue to earn 10% pa. However, you still have an ‘opportunity cost/loss’ compared with the extra 1% that a new investment would now earn.

This risk is the main reason bond funds you buy via a managed fund seem to have more volatile returns than bonds you own yourself. Managed funds must revalue their assets every day to ensure that investors entering or exiting the fund are treated equally. However, if you remain invested the returns over a longer period should look very similar to those you would achieve through a direct investment for the same term.

Liquidity risk
Having decided to ‘cash up’ you are faced with liquidity risk. That is, how much of your capital you will need to give away in order to find a buyer.

Government stock and high credit quality managed funds tend to be very liquid and easily exited but this may not be the case with lower credit quality or highly complex bonds. Even a coupon that is well above current interest rates can affect liquidity as most people don’t want to pay more than the maturity value for a bond.

When buying any non-government bonds, finance company debentures, or one of the more exotic managed funds investors should really consider the investment to be a term loan investment rather than an asset. It is unlikely you will be able to easily sell these assets when you want to especially if there has been any credit deterioration (and this does not necessarily mean default as was seen when Brierley bonds were out of favour several years ago).

Credit risk
This could be better described as ‘default’ risk. Will the bonds pay their coupons and will you get your money back at maturity? Credit default is, pretty much, the major reason you won’t get your money back!

Generally investors manage credit risk in one of two ways.

Active management is a bit like investing in shares where you analyse the company before buying and sell the bonds if the outlook for the company, economy and so on deteriorates. This style of management requires some financial skills but also relies heavily on liquidity, the ability to buy and sell bonds when you need to.

Unfortunately the New Zealand non-government bond market is extremely illiquid except for a very few extremely high quality borrowers.

So if you can’t manage actively you must rely on diversification to reduce your risk. That is, you hold a broad spectrum of bonds from a variety of issuers and Industries so that a single default (you must expect some, especially in lower quality bonds) is not catastrophic for your investment portfolio. This is a major principle behind managed funds and why they are typically less affected by a default.

In New Zealand, however, do it yourself diversification is not really possible. Credit rating agency Standard and Poors only rates around 60 bond issuers ‘investment grade’. Most of these are banks (1/3), city councils or utilities like Telecom and the electricity companies. That means at best, a single default can mean a 1.66% loss in your portfolio even if you hold all 60 issues, assuming that other related borrowers are not affected too. In reality, if one bank fails, the price of other bank bonds will also suffer. But if diversification is a problem with these high quality ‘investment grade’ fixed interest products, it is much worse for the non-rated or ‘speculative grade’ bonds. Many finance companies, for instance, are heavily leveraged to one sector of the market (usually property development), so buying several different finance company debentures will not necessarily provide diversification.

With liquidity and diversification difficult to achieve domestically, you need to be compensated for the additional risk with a large credit margin over government debt. But, in recent times, New Zealand has experienced strong economic growth, low interest rates, almost full employment and booming property markets.

Credit defaults have been largely non-existent in this environment and credit margins have contracted to very tight levels as investors chase absolute yields.

The ongoing rise in interest rates and peaking of the property market is likely to result in an increase in credit defaults in the near future. Consequently, the New Zealand bond market does not currently appear to adequately reward investors for the risk of default.

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