Diversification, security and an adequate return for the risk being taken are key elements

Significant financial events can influence more than the profitability of individual businesses. They can alter the investment attitudes of a generation. The Depression was such an event. In New Zealand the share market collapse of 1987 significantly affected investment attitudes. This decade, and more particularly the last two years, is likely to create a similar outcome.

Where to from here for investment?

That impact is not evenly spread however. Investment into shares will take time to bounce back. Property less so. And despite the failure, freezing or closure of numerous income based organisations such as finance companies and mortgage funds, enthusiasm for the latest good rate appears undiminished. Or at least that conclusion could be intuited from the enthusiasm shown in recent months for company fund raising. Recent issues include Auckland Airport, Fonterra, NZ Post, Tower, Contact Energy and AMP.

Corporate Bonds appear to be an attractive investment currently

This form of debt is generally known as a Corporate Bond (higher security) or a Capital Note (lesser security). The rationale is that the company needs to raise funds. Since the world wide credit crisis began in September 2007, it has become increasingly difficult for New Zealand companies to borrow offshore. The international market is not as keen as it was to lend to small companies on the other side of the world.

When an investor purchases a Bond or a Note they are providing a loan to a company. In exchange for the loan, the company promises to pay interest (called a ‘coupon’) to the investor over the life of the investment. The company will pay either a fixed interest rate (for example, Contact Energy’s recent offer of 7.75%) or a variable interest rate, which is usually pegged to cash rates. In the case of a variable rate, if interest rates rise the company will pay a higher rate of interest and vice versa if they fall (a recent example being Westpac’s government-guaranteed floating rate bond, which returns 0.6% over cash rates). Fixed coupon bonds are more popular with retail investors because they create the illusion of security. But just because the company is a household name and offers a fixed return does not make it a safe investment. Household names do strike trouble from time to time.

Are all bonds created equal?

It has been said that the ability of a company to honour its promise of income should be measured under conditions of depression and not of prosperity. It is also necessary to understand that they are not all created equal. In purchasing this investment we should want to be as high up the security ladder as we can. Unfortunately that space is generally already taken by the bank. That Capital Notes differ in security terms to Corporate Bonds is not readily understood by consumers. Some recent Capital Note issues include Fletcher Building, Infratil and Sky City.

Diversification, security and an adequate return for risk taken

Whether times are good or bad the basics of diversification, security and an adequate return for the risk being taken are key. But in income investing those rules are often ignored. One of the worlds’ great investors Benjamin Graham wrote: “It appears to be a financial axiom that whenever there is money to invest, it is invested; and if the owner cannot find a good security yielding a fair return, he will invariably buy a poor one. A prudent and intelligent investor should be able to avoid this temptation, and reconcile himself to accepting an unattractive yield from the best bonds, in preference to risking his principal in second-grade issues for the sake of a larger coupon return.” Food for thought.

Stephen McFarlane is a Chartered Accountant and Certified Financial Planner. He is an adviser with the One to One Group and Triplejump both of whom are based in Timaru. A Disclosure Statement is available on request and free of charge at www.one-to-one.co.nz.