Money: Bonds safe haven in risky times

By BRENT SHEATHER*

With returns from the stockmarket looking more and more unpredictable and much of New Zealand's population gradually turning grey (this writer included), it is a fair bet that the low-risk and steady income provided by fixed-interest investments will become increasingly appealing.

In fact, last year even ultra low-risk NZ Government bonds outperformed local and international shares.

In more civilized parts of the world it has been unusual for shares to produce lower returns than bonds because shares are generally more risky - so investors demand higher returns to compensate for the risk.

In New Zealand, however, due to the poor performance of our corporate sector, bonds have been the best bet even over relatively long periods.

But bonds have much more than their past performance going for them.

That's because they represent something of an insurance policy against a particularly nasty economic scenario - deflation.

The most recent example of global deflation was in the 1930s. At that time, people who owned long-term US government bonds earning 3 per cent were laughing all the way to the bank.

Why? Because inflation was negative - goods were getting cheaper, not dearer - interest rates at the local bank were barely above 0 per cent, and there was a better than even chance it was going bust anyway.

In a more recent example, Japan has been caught in a deflationary spiral for more than 10 years and over this time interest rates on government bonds have fallen from 7 per cent to 3 per cent a year, giving bond investors big profits.

In another optimistic signal for bonds, many local experts look at the long-term relative performance of US bonds and shares (5.3 per cent and 11.2 per cent respectively, from 1926 to 1999) and conclude that bonds are for ninnies.

They may be right, almost certainly will be right in the long term, but I can't help but worry that anything that obvious has to have a catch. Anyway, not all of us can afford to take the risk of getting things 100 per cent wrong.

For one thing, some older investors don't have a particularly long-term view when it comes to investment, and most people over-estimate their tolerance to risk.

Another issue, and of potentially more concern, is that if we go back in history another hundred years or so to the 1800s, deflation was a lot more common that it has been in the 1926-1999 period. And shares don't like deflation.

Some overseas economists take the threat of deflation very seriously. Indeed, the prospect of it recurring gave many quite a scare in late 1998.

Anyway, I'm not sure bonds are just for ninnies. And, just in case there are a few do-it-yourself ninnies out there who would like to take a more sophisticated approach to their fixed-interest portfolios (apart from just grabbing the highest available yield from the bank), there are some lessons we can draw from looking at how institutional investors manage their bond portfolios.

Once you have decided what level of default risk you are happy with, the next question for those considering fixed-interest investment is: should I go long or short?

Consider the decision facing Grandmother Battler with $20,000 to invest. Does she opt for the 6.5 per cent offered by the bank for one year or the 5.8 per cent available from five-year Government bonds?

No contest - next stop the bank, right?

Maybe not. Mrs Battler's grandson, who is at university studying finance 101, has just read about the Term Structure of Interest Rates, otherwise known as the yield curve.

The yield curve is simple to understand - it is just a graph of the return on fixed-interest investments of similar risk, showing how that return varies depending on the term of the investment.

Yield curves can follow one of four patterns: The ascending curve - higher returns for longer-term investments - is most common and tends to prevail when interest rates are modest.

The declining yield curve - lower rates for longer-term investments - is relatively common, especially when rates are high.

The humped yield curve - lower returns for short and long-term investments, with higher returns for those in the middle - is what New Zealand's curve looks like to me at present. This occurs when interest rates are high and about to retreat to more normal levels.

Finally, there is the flat yield curve - returns much the same regardless of the length of the investment - which rarely exists for any period of time.

Grandson Battler knows that a downward sloping yield curve suggests that interest rates in the future will be lower. That's because, according to the theory behind interest rates, long-term rates merely reflect what investors expect short-term rates to be at that time in the future.

In other words, if three-year rates are low, that's because investors expect short-term rates to be low three years from now.

The market which prices bank deposit rates at 6.5 per cent and five-year Government bonds at 5.8 per cent is expecting interest rates to fall quite rapidly.

Automatically opting for the highest yield and ignoring your investment horizon is often a dumb move for three reasons:

* Theoretically it will not maximise income because the market's expectation is that when Grandmother Battler goes to reinvest her $20,000 the interest rate will be much lower.

* If your investment horizon is longer term and you keep rolling your money over each year, you have a substantial reinvestment risk - interest rates could fall. Investing some of your money for a longer term reduces the volatility of your income.

* Longer term bonds have historically achieved a higher return than short-term bonds. In the US between 1926 and 1999, long-term bonds have returned 5.3 per cent a year while short-term bonds returned 3.8 per cent. This is because longer bonds are more risky.

Over the last 10 years or so, the tight monetary policy pursued locally has obscured the importance of the long-short conundrum because our short-term interest rates have been very high relative to long-term rates.

Normally, however, the yield curve is positively sloped - the yield on long-term bonds is higher than the yield on short-term bonds.

Another, and perhaps the most important lesson, we can draw from institutional fixed-interest managers is the practice of "benchmarking" your portfolio's maturity profile - otherwise known as avoiding losing one's job.

Essentially, the fund managers, when faced with the long-short dilemma, throw up their hands and say, 'we don't know.'

However, because their bosses review their performance relative to an index of NZ Government stock, and because they are resourceful fellows, they simply copy the maturity profile of that index, putting some money short, some medium and some long.

Because the index uses low-risk government stock, all the fund manager has to do to beat the index is copy the maturity profile and then opt for a few more risky bonds (where high yields more than compensate for the fund's annual fees).

They outperform and hey presto, they are fixed-interest gurus and, quite possibly, fund manager of the year.

Private investors can follow much the same strategy, by spreading their money across different maturities.

* Brent Sheather is a Whakatane sharebroker and investment adviser.