Bonds appeal as shares fall

By Neville Bennett

Friday 11th October 2002

In the past three years a vast amount of paper wealth has been destroyed. Those who listened to advice to place all of their eggs in an equity basket have seen 40-50% of their assets blown away in an equity storm.

Moreover, the outlook for global equities remains bleak as the bear market seems certain to rule in the short to medium term.

There will be one-day, 300-point rallies on the Dow; these provide good opportunities to sell down holdings and move into cash. Despite the litany of "buy" from self-interested fund sales people, this is a time to retain the old rules of diversification, especially to preserve capital.

Fixed interest investments are good performers. Historically, they have outperformed the New Zealand stockmarket in the past four decades. This is partly because domestic savings are low and interest rates are generally higher than in the major markets overseas.

Moreover, New Zealand stocks have performed quite badly, except in the mad mid-1980s.

Certainly, an investment in fixed interest would have outperformed equity funds in the past three years.

The bond market is a particularly sound investment in this era of uncertainty. Bonds provide a useful yield and may also provide a small capital gain if interest rates decline (as seems quite possible).

It is an easy market to enter and entry costs are cheap compared with funds. Brokerage fees vary little and rise on longer maturities (for no obvious reason than it suits brokers).

Forsyth Barr says a fee of around 0.5-0.75% is general. This is reasonable so a portfolio is free of those ingenious little charges funds impose. There is an economy to buying bonds, as a $10,000 stake is usually a minimum with some parcels having a $100,000 minimum.

Most bonds are credit-agency rated. Government bonds (NZGS) and banks have a secure rating of A. Business varies from A+ to BBB.

New Zealand is fortunate in that it does not have the vast sea of C grade paper found in other markets: C-grade has a high default rate.

The rating system increases investor confidence. Moreover, some companies and trusts are unable by law to buy unrated assets.

But the process is expensive and perhaps not cost-effective on smaller issues. Consequently, quite a number of local authorities and businesses do not apply for ratings. Most unrated paper is nevertheless quite sound.

The market gives its verdict on soundness by driving the capital price of the bond/note up or down so that its yield is high or low relative to other offerings. The golden rule is, of course, the higher the yield the greater the risk.

For example, Wellington City's paper is unrated but it is highly regarded in the market and its price has been driven up to a yield of 5.93%.

The market is more suspicious of BIL, whose capital notes have a coupon rate of 9.25% but a yield of 14.5%.

NZGS is rightly regarded as risk-free as the state can fall back on taxpayers to honour its undertakings. By international standards its present yield is remarkably good, falling in a range of 5.58% to 6.13%. Ten-year NZGS yields about 6.09%.

In comparison, the 10-year yields for the UK are 4.42%, the US 3.63% and Japan 1.17%. The margin is large and some capital gain would result from any convergence.

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