KEY POINTS:
Investors who have seen so-called low-risk fixed interest investments almost halve in value may have been misled - or mis-sold to.
The products in question include Macquarie Fortress Investment notes and ING's Regular Income Fund and Diversified Yield Fund, which invested in highly complex mortgage-backed investments designed to
give a higher return than corporate bonds.
Many of these products have come unstuck thanks to the global credit crunch; in some cases leaving conservative investors without interest payments.
Ironically, most of the underlying securities in funds such as the Fortress notes are still making interest payments. The problem lies in the fact that the funds had borrowed money to buy the underlying investments, and lenders are calling in some of those loans now that values have fallen, because their rules required repayment in such circumstances.
Some funds have had to sell units in order to meet the lenders' demands, pushing their unit prices down. In addition, says David Speight, head of fixed interest at Direct Broking, the fact that private investors find the products difficult to understand means they are not likely to be buying in the current uncertain market.
While many investors were led to believe that these products were low or medium risk, it has emerged that some of the highly structured products, such as those offered by Credit Sail, Generator Bonds, HY-FI Securities, PNZFA and PNZFB, were not as straightforward or perhaps as low-risk as corporate bonds issued by names such as Fonterra, Infratil or Vector.
Some of the funds are invested in what are known as collateralised debt obligations (CDOs) - a complex form of investment that promised to boost returns from fixed-interest investments (see "Financial Engineering", right).
To add to the impression that these investment vehicles are low risk, some of the issuers offer "capital guarantees".
The problem is, many investors simply don't understand what that means. In the case of the Fidelity Guaranteed Income Bond, it doesn't mean there is a guarantee that it will pay on time.
In fact, the January 15 interest payment was suspended according to the fund's rules. Yet investors who depend on interest payments have been caught by surprise.
What's more, says Grant Hassall, head of fixed interest and cash assets at AMP, a guarantee is only as good as the entity guaranteeing the capital and if that's an issuer, not a bank, then investors should be questioning its value.
What many investors don't realise, says Speight, is that throughout the life of the investment, the value can fall below the issue price and that the capital guarantee doesn't kick in until maturity.
Many of the structured products had good investment-grade ratings from agencies such as Standard & Poor's.
The problem is that, come the crunch, structures such as the Fortress Notes were invested in illiquid assets - things that couldn't easily be sold - and borrowing magnified the impact of any falls in value of the underlying assets.
Some financial advisers and private investors are now questioning the selling of complex structured investments in the recent past. It appears they were being sold as alternatives to bank deposits and the risks were not spelled out.
When I searched online, I found the ING Regular Income Fund described by a financial planner as suited to "low to medium risk investors" looking for alternatives to short-term bank deposits and other fixed interest investments.
Nowhere did I find it mentioned that the underlying investments might be based on US sub-prime mortgages - although in fairness this probably would not have raised alarm bells before the present credit crunch.
Marc Lieberman, chief executive of ING New Zealand, points out that the investment statements for his products made it clear that there were risks and that prices could rise and fall.
What's more, says Lieberman, the financial markets have been taken by surprise by the global credit crunch, which was more severe than the Asian and other recent financial crises.
Despite the current crisis, says Robert Oddy, director of International Financial Planners, investors should think twice about pulling their investments from any market just because of short-term declines. Private investors who pulled out of the share markets after falls in 2000 and 2003, said Oddy, missed out on the rapid recovery.
Ultimately, Hassall says, investors in some of the structured products that are now in trouble are likely to get their capital back, if they're patient.
Financial Engineering
* Collateralised debt obligations (CDOs) are investments backed by a pool of bonds, loans or other assets - as opposed to investing in a single bond. Investors who buy into CDOs can choose various levels of risk, in exchange for higher or lower interest payments. In practice, the problems in US financial markets have shown that many CDOs were much riskier than initially suspected.
Diana Clement is an Auckland-based personal finance and investment writer.
