Bond funds worth closer look

THE WAR CHEST: Like a squirrel hoarding nuts, companies are storing away debt with many planning to issue retail bonds.
THE WAR CHEST: Like a squirrel hoarding nuts, companies are storing away debt with many planning to issue retail bonds.

Like squirrels stuffing their little cheeks with nuts, companies like to fatten up on debt at this time of the economic cycle.

It's a natural urge and quite common, so we shouldn't be surprised to see more of them hopping about issuing bonds, balance sheets bulging.

As investors on the receiving end of these offers we must decide whether we want a piece of the action. After all, the rough rule of thumb is that bonds don't do well when interest rates are rising and the Reserve Bank has made it clear the official cash rate is on an upward path.

At last month's OCR announcement it said: "There is a need to return interest rates to more-normal levels. The bank expects to start this adjustment soon."

The reason bonds are not so hot in this situation is that a yield of, say, 4 per cent might look fine when the benchmark rate is 2.5 per cent, but it's not worth as much if the benchmark rises to 3.5. Thus the market value of a fixed rate bond will fall as other interest rates rise.

Traditionally the way to deal with that in bond portfolios is to invest only in short-term bonds or cash, so that money can be regularly reinvested at higher rates.

However, this doesn't mean investors should necessarily shun bonds this year.

Grant Hassell, head of fixed income at fund manager AMP Capital, says he's expecting an increase in offers of debt securities aimed at the retail market.

"A lot of retail investors will find these attractive, solely because it's got a higher yield than their term deposits.

"But higher yield doesn't necessarily mean a higher return."

It sounds counterintuitive, but Hassell is referring to the way the market prices debt that matures at different times. Debt repaying in six months may be priced with a yield of 3.2 per cent; a one year maturity may be priced at 3.5 per cent; and a two-year maturity have a price of 3.9 per cent.

Plot those market prices against time on a graph and you get what bond people call a yield curve.

It appears that the two-year maturity has a higher return than the six-month, but it doesn't really. If interest rates move the way the market expects, when the six-month bond matures the money can be reinvested at a higher rate, and so on.

All else being equal, the investor buying a series of six-month maturities will end up with the same return as the two-year.

The current market is expecting rising interest rates, so longer maturities are carrying a higher yield than short.

"The yield curve in New Zealand is quite steep now," says Christian Hawkesby, head of fixed interest for Harbour Asset Management. "So for five-, six-, seven-year bonds the yields are much higher than the OCR, in part because the market's anticipating that rise."

With a certain level of rising rates priced in, investors are less exposed when going for medium-term bonds.

However, "if they thought interest rates are going to rise faster they would hold off and stay in cash and invest in bonds later".

The other main factor to consider when these offers come to market is the credit risk. Companies issuing bonds have different degrees of financial strength, and even a strong company may issue bonds with a low level of security over its assets.

There is no easy way to judge whether a bond is priced correctly for its risk, but the market prices of similar securities on the NZDX can be a guide.

Most of us would probably find these judgment calls as easy as eel wrestling in an ice rink, but there are ways to pass the buck.

One is to use a bond fund.

AMP has a couple - the Short Duration Fund and the Fixed Interest Fund - as does Harbour, the Core Fixed Interest Fund and the Corporate Bond Fund, but there are several others on the market.

These funds have different purposes so it's important to select one with the right fit. Some are intended to offset the risk of holding shares in a portfolio and will perform best when shares are poor, and vice versa.

Others are intended to generate income.

Unfortunately the level of disclosure around returns and fees is as variable as in equity funds.

Harbour's fact sheets show returns before tax and fees, for example, while AMP's show returns before tax, fees and assuming income is reinvested.

To my mind, the income reinvestment assumption is not helpful for a fixed interest fund and Harbour's clear disclosure of its quarterly distributions gives a better idea of what to expect.

Based on unit prices at January 31 and last year's distributions, the cash yields for the Harbour Core and Corporate Bond funds look like 3.4 per cent and 4.4 per cent respectively.

Actual returns are different again, of course, because the fund values and therefore the unit prices will vary with the market values of the bond holdings. But these are not knock-your-socks-off investments - they fulfil the same function in a portfolio as directly held bonds - and for DIY investors they are worth considering as a way to deal with the complexities of bond exposures.

Tim Hunter is deputy editor of the Fairfax business bureau.

Sunday Star Times