By MARY HOLM
Q. I have just come across "Laddered Portfolio" theory. That is, you invest in fixed rates at different maturities so that you are exposed to different interest rates.
Say you invest in one-, two-, three-, four- and five-year bonds/term deposits or whatever and you obtain a range of rates.
After a year your one-year bond matures and your two-, three-, four- and five-year bonds have one year less to run. So you would invest in another five-year bond to balance the portfolio.
However, after five years all your bonds are now five-year bonds, with different maturity dates.
Therefore, during this process you are only investing in long-term rates and miss out on short-term rates, defeating the purpose.
This is especially detrimental if short-term rates are higher than long-term rates, as you have been investing in only one maturity range.
There lies my problem. How do you reinvest the bond that matures so as to continue to enjoy both short- and long-term rates?
A. You could simply follow your plan with part of your money, and invest the rest in one-year bonds, which you keep rolling over.
But I think you're missing the point of laddering.
The idea, as I understand it, is to get all your money into long-term investments, but avoid having the whole lot mature at once, when interest rates might happen to be at a low point.
Also, at any given time you'll have some money maturing within a year, which is good if you need it unexpectedly.
You certainly do end up missing out on short-term rates. But that doesn't defeat the purpose. It's a good result.
Why? Most of the time, you'll earn higher returns on five-year investments than on shorter-term investments.
And even when that doesn't seem to be the case, you will usually end up better off going with the longer terms.
To explain this, we'll look at four typical scenarios.
Scenario One: Interest rates are not expected to change in the near future.
One-year rates are 5 per cent; five-year rates are 6 per cent.
The long-term rate is higher because the bank or company in which you are investing prefers to have the money tied up for a longer period.
Scenario Two: Interest rates are expected to rise over the next few years.
One-year rates are 5 per cent; five-year rates are 7 per cent.
When expecting rates to rise, you will be tempted to invest for one or two years, so you can roll over into higher rates later.
The bank or bond issuer who wants your money for five years must entice you out of that by paying extra on five-year investments.
Scenario Three: Interest rates are expected to fall a little over a few years.
One-year rates are 5 per cent; five-year rates are 5 per cent.
The bank or bond issuer has mixed feelings. They want to tie up your money, but also know that if they wait a year or two, they might be able to pay lower rates. In other words, the tie-up factor and the falling-rates factor offset one another.
Meanwhile, you are also expecting rates to fall, so you will be willing to tie up your money for longer, even though you get only the same rate as for one year.
Scenario Four: Interest rates are expected to fall a lot over a few years.
One-year rates are 5 per cent; five-year rates are 4 per cent.
This is a "negative yield curve", with higher short-term rates than long-term rates. The falling-rates factor dominates the tie-up factor.
As I said above, even in this situation you should probably stick with the five-year investment.
If, instead, you choose a one- or two-year investment and keep rolling it over, by the end of four years you may be stuck with making only 1 or 2 per cent.
Roughly speaking, the five-year rate will be the average of one-year rates expected over the next five years, plus extra for tying up your money.
Still with me? The main points are:
* Negative yield curves are fairly unusual. They happen only if a big interest rate drop is expected.
* Even when they apply, investors are usually better off with longer terms.
We should note here that interest rate forecasts are often wrong, especially when we're looking five years out.
In our fourth scenario, for example, if you invested for five years and rates didn't fall, you would wish you had gone with one-year investments, rolling over.
But if they fell more than expected, you'd be really pleased with your choice.
Over the long haul, forecasting errors should help you as often as they hurt you.
Conclusion: If you're in fixed interest for the long term, laddering is a good idea.
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Q. Further to the subject of equity release programmes, it is my pleasure to announce that help is at hand, or at least nearly.
In the very near future we will be able to offer a product where, among others, "asset-rich cash-poor" people can invest (part of) their liquidated assets in a trust fund which has over the past five years achieved a high return.
As mortgage brokers we have been looking at reverse mortgages, but we've dismissed them as being too expensive for a very disappointing monthly return.
Our new product does NOT require that people sell their home - they just borrow against it and invest the funds in mortgage-backed semi-government bonds.
Investors can keep a finger on the pulse of this investment by checking its performance on the fund manager's website on a fortnightly basis. Also, all or part of the investment can be withdrawn fortnightly, no questions asked.
As the fund has grown by some 125 per cent over the past five years, investors can look forward to a yield of some 18 per cent, which results in some 11 per cent net return after allowing for interest payments.
Investors who are able to invest a minimum of $500,000 can open an account in their own name and can expect a net yield of around 25 per cent.
These investment construction loan programmes are hugely popular in some European countries, and have been running there for the past 30 years with full permission by the local securities commissions.
When we're ready we will seek backing by the New Zealand Securities Commission, and we'll make sure that we comply with all relevant legal requirements.
We thought this might be of interest to you, and we will advise you when this type of investment will be offered to the New Zealand public.
A. Thanks, but I'm afraid I won't be passing on the information. Your new product looks too good to be prudent.
For those not up with the play, this column has recently included several letters about "whatchimacallits". As I said last week, I'm not sure of the best title for products that enable people, usually retired, to spend some of the equity in their homes while still living in them.
Here's a recent comment from Judith Davey, director of Victoria University's NZ Institute for Research on Ageing, who has done lots of research on the products.
"In my opinion 'equity release' and 'home equity conversion' are, respectively, the British and US overall names for a range of ways in which equity can be released to provide income or lump sums.
"Reverse mortgages are only one of these ways. I also think that the emphasis on reverse mortgages has obscured the other methods of equity release, which may be more suitable for many people."
Given that "equity release" is shorter, let's use that name.
Back to the letter. At first glance, it sounds so easy. Borrow at 7 per cent, invest the money at 18 per cent or even more, and spend the difference.
And words like "mortgage-backed" and "semi-government" sound comforting.
Great! Or is it?
I'm not saying the fund in question hasn't made that rather wonderful return. What I am saying is that any investment that pays that much must be pretty risky.
How can I be so sure, when I know nothing of the fund?
Simply by looking at the returns. Whenever anyone offers you a high return, ask yourself why. It's usually because either:
* They can't raise cheaper money elsewhere, because traditional lenders aren't confident they will get their money back. Would-be investors should be equally sceptical.
* There's gearing - borrowing to invest - involved. That always raises returns and risk.
The cold hard fact is that any time you take out a mortgage to invest, you must venture into risky territory.
Your after-tax return has to be a fair bit higher than the mortgage interest rate.
That means going into shares, property, or perhaps a fund like the above.
All those investments sometimes work well, and sometimes don't.
I shudder at the thought of retired people who borrowed to invest, obliged to meet mortgage payments, watching as their investment doesn't generate enough income or grow enough to cover those payments - or even falls in value.
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