By MARY HOLM
Q. This is how I try to put riskier fixed-interest returns in their place.
On $10,000, I can earn about 5 per cent or $500 a year in the bank for a five-year term at the moment. In a higher-risk finance company or corporate capital note, I can earn about 8 per cent or $800 a year.
I always ask whether I need the extra $300 a year taxable income so badly that it is worth risking losing part or all of my capital and income in the future. If not, why bother?
If I do need the extra $300, am I just as well off accepting 5 per cent or $500 a year and spending $300 of my capital, knowing that what is left remains more secure, even as my remaining capital declines?
You referred to a 2.5 per cent risk of losing your capital for BBB rated investments. I actually think this risk relates to a risk of default, with possible loss of part or all of capital following.
I think that this risk increases to about 15 per cent for debt that is not rated by rating agencies, but I will leave you to confirm that.
I think this means that, if you hold all your investments in a well-diversified portfolio of unrated "junk" fixed-interest investments, over about 6 1/2 years, about 15 per cent of your portfolio will suffer a default.
However, these are averages. In the relatively good economic environment we have at this time, it is not surprising that you cannot recall too many failures (but how short can people's memories be? - Metropolis junk bond default and others similar!) In difficult economic times, the averages could come home to roost with 50 per cent or more of investments defaulting within a short time.
How many investors can predict that time? How many could realistically suffer losses of that level and maintain their lifestyle?
If you cannot stand that amount of heat, get out of that particular kitchen before the downturn begins (whenever it might be - I am not trying to predict it).
A. It's always a good idea to calculate the difference in interest when you are considering alternative investments.
As you say, $300 is not a huge amount on a $10,000 investment. And, after tax, it's quite a bit less again.
And I like your point about taking the relatively small difference out of capital, if necessary.
It's worth noting, though, that over the long term the difference between 5 and 8 per cent is pretty noticeable.
At 5 per cent, $10,000 would grow to $16,300 in 10 years, and $26,500 in 20 years. At 8 per cent, it would grow to $21,600 in 10 years and $46,600 in 20 years. That's a lot more.
Then again, if someone is investing over 10 or 20 years, I would be urging them to invest in shares or property.
Over that length of time, diversified share and/or property investments are highly unlikely to lose money and highly likely to bring in higher returns than fixed interest. It's also worth noting that, for all that shares and property tend to be riskier than fixed interest, that's not necessarily true with high-return fixed interest products.
Unsecured, subordinated capital notes are almost as risky as shares in the same company, without the potential for capital growth that shares have. High-interest finance company investments are just as worrying.
If you stick with just one or a few such investments, your portfolio would almost certainly be riskier than diversified investments in shares and/or property.
What you say - and I know you are a reliable source - tends to confirm that.
I don't know about your 15 per cent risk figure. Does anyone have data on that? If it's correct, that's pretty frightening for people who think all bonds, notes and so on are pretty safe.
I'm afraid this week's column is again dominated by fixed-interest issues.
Oh well, property and shares have had their turn in the past.
And so many people have invested - or are thinking of investing - in fixed interest beyond bank term deposits that I think it's worth going into the topic in depth.
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Q. Re your article on June 21 about Goodman Fielder capital notes, I would just like to add another reason these notes pay 10 per cent interest.
Fernz issued similar notes a while back at interest rates far higher than you could borrow money from the banks.
The reason they offered a much higher rate is simply to attract money that their company bankers were not prepared to lend them, because of their own balance sheets.
Perhaps Goodmans are in the same boat.
A. I'm sure they are - at least to the extent that they couldn't raise the money at a lower interest rate from elsewhere, or why wouldn't they?
It's always illuminating to look on the other side of an investment, and ask why the company is offering you this deal.
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Q. Thanks to your advice in your column last week, I scaled back my investment in Goodman Finance and also limited myself to purchasing the five-year notes and not the eight-year notes.
My reasoning was that a default, if it were to happen, would likely happen later rather than sooner. And the extra 0.2 per cent didn't offset the additional risk I saw with committing to an additional three years.
P.S. I am not increasing my mortgage for my investment in Goodman Finance.
A. It's great to know the message got through.
It can get pretty silly, borrowing to invest in something risky for not a huge gain, especially after tax.
Just a note about the difference between the five-year 9.75 per cent rate and the eight-year 9.95 per cent.
Whenever you see a surprisingly small difference for a considerably longer term, that means the experts are predicting that interest rates will fall over the period.
If the interest forecast was flat, you might get, say, 10.5 per cent for eight years.
Those who realise that may opt for the eight-year notes, despite their small margin over the five-year notes. They expect in a few years time to be pleased to have their money tied up for eight years at what, by then, looks like a particularly good return.
Still, interest rate forecasts - while generally more reliable than share market or foreign exchange forecasts - can be wrong.
And I take your point that a shorter term investment seems safer if things look a bit iffy.
There are, of course, those who would say that even five years is a long time in corporate history.
But let's not get into that. You've made what sounds like a reasonably prudent investment. And while it's far from a sure thing, the chances are good that it will work out fine.
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Q. I would like to comment further on the letter in your June 14 column on how
lend money out at 6.1 per cent (now lower) whereas a number of finance companies are borrowing funds from the public at rates in excess of 8 per cent.
The reason is as follows: Cairns Lockie is a mortgage lending company. We offer these attractive rates to source prime first mortgage securities from borrowers with good income and a clean credit history.
All lending has to be funded. A company such as ourselves uses a wholesale funding process known as securitisation, accessing local and international capital markets.
As well as offering our investors a security based on prime residential first mortgages, we obtain lenders' mortgage insurance on all our mortgages.
This offers another layer of security protection to our investors and also provides those who purchase our mortgage-backed paper an AA credit rating.
As a result, we fund at a rate just over the Government stock rate.
As we can borrow at a low rate, we lend at a lower rate.
The finance company cited is not in the same market. Their security is different and without the benefit of lenders' mortgage insurance. Therefore they are required to fund at a higher rate.
Some commentators are suggesting that rates offered by finance companies do not adequately compensate for the risk assumed. We agree.
At the end of the day the rate you borrow and lend at is really a function of what security is being offered and the overall level of risk.
A. This subject is really bringing people out of the woodwork who want a free ad.
I've rejected the other letters. But I think your explanation of how your company operates is helpful, so you're in.
While we're on finance companies, a comment from ABN Amro Craigs' Cameron Watson was deleted last week for space reasons. But I think it's worth running.
He said: "Recently, a rash of small finance companies we've never heard of have arrived on the scene, probably trying to cash in and make some quick bucks. It's safer to stick to a name that's been around for years and years."
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Q. I run a finance company and my term deposit rate on offer is 10 per cent (fixed).
Even once you've paid the tax, there is a sure dollar to be made for the punter. The question is how risky is the ticket?
I fully endorse the comments made in your reply two weeks ago. I would, however, go further and recommend that the investor does their own due diligence on the company they want to deposit with, its track record and its operators.
Price does not always equate to risk (look at the Metropolis bond price v risk).
Further, all the ratings and so-called "debenture" security can turn to naught when the company goes belly-up.
I would also take independent ratings such as Bondwatch with a grain of salt - but agree, through want of any other analysis, that some is better than none.
I am a niche market operator with investors secured only by my personal guarantee and my "moral mortgage". For this reason, I continue to pay above market rates.
Caveat emptor.
A. You write about a "sure" dollar, but then go on to say it's unsure. That's the whole point.
It's hard to argue with doing your homework before investing.
The trouble is that most people don't have access to anything more than prospectuses and investment statements. And many don't really understand those. Even those with Accounting or Finance 101 can easily be bamboozled by pages full of numbers.
The Bondwatch people at least have a better idea of what they are reading than most of us.
But I wouldn't suggest investing based only on their ratings. A good stockbroker or financial adviser should be able to give some guidance on fixed-interest products.
If, after that, you still feel you don't really understand how the company works, or don't feel confident of its performance, stay away.
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