Diana Clement: Beware the high interest lure

Turn on the TV today and the chances are you'll be hit with reassuring adverts inviting you to invest in "first ranking debenture stock".

You could be forgiven for thinking that your money couldn't be safer. But before you pile your life savings into Pacific Retail Finance, the company behind the adverts that keep capturing my attention, or any of the 80 plus other finance companies in the country, you need to ask some questions.

In colloquial English, first ranking debenture stock is a term deposit, which, in turn, is an interest-bearing account offered by institutions such as banks, building societies and finance companies.

The interest rate is fixed for a certain period of time and, at maturity, you receive the interest, which may have been compounded over a period of time, and the amount invested is returned.

All up, interest.co.nz's research shows that people have more than $72 billion invested in retail term deposits. About three-quarters of that is at the four main banks. The remainder is with finance company debentures, building societies and other co-operatives such as the PSIS.

Rates of interest on term deposits vary hugely - often ranging from 4 per cent at the bottom end up to 12 per cent or more.

But investors often haven't a clue about the risk, thinking term investments are safer than the share and property markets.

"People think '11 per cent, great rate, see you later, I'll have some of that' and invest," says Steven Anderson, managing director of cannex.co.nz.

It was the same in September 1987, said James Munro, chief operating officer of Superbank. "Most people didn't understand sharemarket risk. By November, they understood."

Memories fade and it has been a long time since an investor lost his or her life savings in a finance company collapse. Ironically, collapses are most likely to happen when the property market is in trouble - because many of the finance companies lend on commercial and residential property.

Consequently, investors who may think it's the wrong time to invest in the property market put their money into term deposits - at the height of the risk cycle, says Anderson.

"We saw firms fall over in the 1990s when the property market was down."

That's when fallen heroes of the investment world, including Chase Corp and Judge Corp, went bust. Few investors got their money back.

Investors who held debenture stock in Equiticorp - which went into statutory management in 1989 - have received more money than expected, but not all they invested.

Anderson said he would not put his own money in term deposits. "The disclosure requirements are woefully poor."

He'd prefer to invest in equities. He says the disclosure requirements for listed companies allow him to make an informed decision.

Banks are safer for term deposits, says David Chaston of interest.co.nz, because they are regulated by the Reserve Bank and, in his opinion, would not be allowed to fail by Governments on either side of the Tasman.

But those investors wanting a greater return than the 6.4 per cent offered by the ASB or 6.35 per cent by Westpac for $10,000 over three years need to run the gauntlet of finance companies.

A little knowledge and research by investors or their financial planners can help lessen risk.

Finance companies' assets range from $2 million at the bottom end, says FundSource research manager Binu Paul, to $2 billion for UDC Finance "a quasi-bank". But size doesn't necessarily equal safety.

Singling out a safe investment involves cutting a path through the comforting language used in adverts.

"First ranking debenture stock" - one of the more common term deposits on offer - sounds like pretty solid stuff.

What it means is that in a collapse, your money will be repaid before other investors. A cynic would say that you get first dibs on nothing should the company go belly-up.

It's common with first ranking debenture stock to see asterisks and small print that says "subject to prior charges", which means other creditors such as Inland Revenue are ahead of you if the firm collapses, says Anderson.

Even so investors can and should download the investment statement and read it.

Munro says the question to ask yourself is what the finance company is using your money for.

If it is lending on apartment blocks or to people in lower socio-economic areas to consolidate debt, then your investments might be the first on the block when a finance company does go to the wall.

The Securities Commission has its eye on the term-deposit market and its investment statements.

This year, it ordered several finance companies to improve their disclosure documents so that the public could understand the risk of their investments better. Those that don't comply face enforcement later this year, says commission general counsel.

Interest rates are also a good indication of risk. The higher the rate, the more risky - and it's an exponential increase, says Anderson.

If the risk doubles by investing with one finance company over another that has stronger fundamentals, the interest rate can't double, it must simply go up.

So consequently 12 per cent offered by Contributory Mortgage Investments is more than double as risky as the 6 per cent offered by Nelson Building Society for $10,000 over one year using this logic.

Munro questions why investors will bother with the additional risk if they can get rates of 6.7 per cent on call at banks such as his, although he does concede that some investors prefer the certainty of a fixed rate that doesn't change for a period of time.

Several rating systems are popping up. Rapid Ratings rates many of the finance companies with its system, interest.co.nz has a SQP Score "ranking" system and depositrates.co.nz uses the Grosvenor system, ranking companies from G1 to G8.

Cannex.co.nz, which this week launches a rating system for deposit accounts, is working on a system for term deposits.

There has been a lot of in-fighting about these systems, but the reality is that they give mum and dad investors some sort of benchmark to make sense of the small adverts.

Even if you buy into the idea that some finance companies might fail, says Chaston, "it will be a handful of the 87 at most and, with some simple diligent investigation, you can greatly reduce your chance of selecting one of those".

The trick, as with all investments, is to spread them around. Don't put all your life savings in one investment.