Well-heeled find protection

By Neville Bennett

Friday 18th October 2002

The wealthier investor will appreciate that in this turbulent era it is imperative to give priority to the preservation of capital.

Imagine an investor who switched to the S&P500 on Wall Street on January 1, 2002. Last week marked a 50% drop for the year.

Equities can be horrendous in their risks. In contrast, bonds are important for preserving wealth and for providing a useful yield on capital. But as interest rates are at the low end of their cycle, bond yields are relatively low, though still worthwhile.

Does this imply bonds are risk-free? Not quite. It is improbable the New Zealand government will repudiate its obligations. Mind you, three years or so ago, one might have been confident the rigorous Argentinean authorities would have honoured their commitments at all cost. As it happened, last week they failed to pay interest on their bonds.

In New Zealand, the risks are of galloping inflation. The consumers' price index (CPI) is uncomfortably close to 3%.

The government is not interested in hard money. It lacks the Calvinistic streak of Switzerland. Indeed, it is little known it has inflated M3 money supply about 30% in the last two years.

It must be admitted the Reserve Bank, with which I have discussed the point, denies a simple relationship of M3 and inflation. This is contrary to my education and the most effective economist today, Paul Krugman, does not support it.

Nevertheless, if the CPI remains close to 3% a year there will be an erosion in the real value of money and the bonds yields will provide a low real return. The only compensation is that this is better than most other countries. Another risk is that interest rates may be increased, thereby depressing bond capital values.

New Zealand government stock yields about 6%. This is a good yield. In contrast, US treasuries are providing the lowest yield since 1958 and the five-year bond (2.74%) is actually lower than the deeply depressed years of 1930-34. Yields may fall further in the short term if this is the correct interpretation of Alan Greenspan's enigmatic statements.

Can the risks on a New Zealand government stock portfolio be further reduced? I have thought of this in response to a reader's inquiry. Actually. It seems a good time to restructure, adopting a laddering strategy.

Rich investors often use laddering overseas on the advice of elite advisers. It is possible to follow this strategy with an outlay of about $30,000. It is almost unknown here but is quite simple. The investor buys bonds of differing maturities. A key part of the strategy is to hold the bond to maturity to obtain all dividends and a full repayment of the capital.

With more than $30,000, an investor can create longer ladders. Theoretically, there is no problem in creating a 10-year ladder in New Zealand. Actually, there may be problems of availability and there are some years in which no New Zealand government stock is maturing. This includes 2006-08,2010 and 2012. Local government or corporate bonds could fill gaps.

Why are 10-year ladders attractive? The answer is simple. When interest rates rise, the capital value of bonds fall. A 10-year ladder built now will give good dependable returns with only a small risk of losing a little ground if rates fall temporarily in the short term.

But as rates are quite low relatively now, the chances may seem weighted toward higher rates in the medium term.

This issue is important. I do not have an accessible run of New Zealand data but US long bonds have lost value in 38 of the 76 years since 1926. That is half the time. Shorter maturities have lost money about 45% of the time. Thus the ladder strategy should enable some high net worth investors to maintain some security in this menacing environment.

While bond have lost market value in half the years since 1926, it should not be assumed history will repeat itself. The mid-20th century was inflationary and this may be an aberration.

It is possible falling rates, which characterised the 18th and 19th centuries, will assert themselves. The beauty of the ladder is that the investor is immune to change.

In a bond ladder strategy, an investor orders bonds maturing in one, two and three years. This is a three-year ladder.

After one year, when one bond matures, the investor buys another bond, maturing in three years.

This strategy aims to produce more yield for less risk. It is relatively cheap in that brokerage is less for earlier maturing stock than for longer yields.

The strategy reduces anxiety. An investor is fully committed, putting all of his resources to work, but also knows precisely when the government is going to pay dividends and redeem capital.

It is a reliable cashflow. Above all, the investor need not read the paper every day and become anxious. Cashflow is assured.

Essentially the investor is immune to interest rate changes. These may be a paper loss or gain, owing to market movements but these have absolutely no effect on the ultimate yields.

As a third of the portfolio matures each year in this example, the investor has a good cashflow of dividends and capital. If cash is needed for an unseen purpose, the investor can wait for maturity rather than having to sell property or equities at an inopportune time.

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