Climbing the ladder to reduce fixed-interest risk

By Mary Holm

Tuesday 2nd April 2002

Interest rates are rising again, and the experts are expecting further rises over the months ahead. What does it all mean for the investor in fixed interest?

"Some investors," says one newsletter, "may opt to hold cash now and reinvest after rates rise."

That doesn't make a lot of sense. Everybody knows that interest rates are likely to go up. That knowledge will already be reflected in returns.

Take term deposits, for example.

As I write, the big banks are paying 5.1 to 5.5 per cent for one-year deposits of $10,000; 6.1 to 6.45 per cent for three-year deposits; and 6.5 to 7.0 per cent for five-year deposits.

(The information, incidentally, comes from a handy website, www.interest.co.nz)

There's nothing unusual about earning higher interest for longer terms. After all, you're willing to tie up your money for longer, so you should be rewarded for that.

It's common to see higher long-term rates, even if there are no expectations of future rate rises.

But the current rate differences are pretty big. The implication is that rates will rise.

Look at it this way: You've got $10,000 to invest in term deposits for five years.

You could put it in a one-year deposit at 5.5 per cent. A year from now you might be able to renew it at 6 per cent. Then 6.5, 7 and, in the fifth year, 7.5 per cent.

Or you could go for a five-year deposit now, and earn 7 per cent for all five years.

With the first option, your average return is 6.5 per cent - lower than the second option.

But it gives you flexibility. If you unexpectedly need the money, you won't have to break the term deposit for so long, so the penalty won't be as great.

If, on the other hand, you're willing to tie up the money for five years, you get a higher return for doing that.

Nobody knows, of course, if one-year rates will in fact rise by half a percentage point a year for the next five years.

But current rates suggest that the experts expect something like that to happen.

So where does it leave you, if you've got cash and are sitting on the edge of the pool?

You might as well dive in now. After all, you won't be earning much by staying in cash.

You could be annoyed later if interest rates rise faster than currently expected. But you'll be glad if they rise more slowly than expected.

What matters is not whether rates rise, but what happens to rates relative to expectations.

There's a way to reduce the risk that expectations are wrong, too. That is to spread your money over different terms.

With this strategy, sometimes called "laddering", you set up your fixed interest investments so that roughly equal amounts mature a year from now, in two years, and so on, up to perhaps five years.

If you want to continue to hold the money in fixed interest, when an investment matures, you renew it for five years. So the investments keep leapfrogging one another.

That way, you'll be renewing some investments when rates are low; some when they are high. You don't get the best over all, but you also don't get the worst.

The strategy works with corporate bonds, local government bonds and so on, as well as term deposits.

It's another example of diversification - this time over time.

Footnote: Sometimes, interest rates are lower for longer term investments. For example, a five-year term deposit might pay less than a one-year one.

That means the markets are expecting interest rates to fall considerably.

Mary Holm is a freelance journalist and author of "Investing Made Simple", commissioned by the New Zealand Stock Exchange to write an independent personal investment column. She can be reached at maryh@pl.net.

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