Alarm bells are ringing about the state of the fixed interest market in New Zealand. And some industry commentators have claimed that it is not a matter of if, but when, one of the marginal fixed interest issuers goes under.

Members of the Society of Independent Financial Advisers (SIFA) heard at their recent conference in Rotorua that there is significant probability of default among smaller finance companies (Good Returns, “Red lights flashing”, June 10).

The Sunday Star Times warned that investors are often not paid rates of interest reflecting their real risk (“Investors in unrated securities getting raw deal”, June 15). And research quoted from ABN Amro Craigs indicates that Kiwi investors are receiving between 1% and 4% less interest on domestic unrated debt securities than savvy American investors would demand.

PIMCO’s* bond expert John Wilson told a similar story when he visited New Zealand in March this year. Wilson’s view was that the interest rates paid on non-government domestic bonds were too low and did not remunerate investors adequately for the risk, in short that such fixed interest was priced too expensively. Consequently, his fund does not invest in such securities, instead spreading its investment across more than 250 global bonds.

Wrongly risk-adjusted interest rates not only short-change investors, but also signal falsely the relative degree of security involved. In the absurd extreme, two fixed interest investments might have the same level of risk but one might offer, say, 8% while the other promises 12%. An investor who shuns a “dodgy” 12% to invest in a “safer” 8% unwittingly enters a risk category unacceptable if accurately priced.

Not all fixed interest offerings are created equal

There have been a number of defaults on high risk property bonds and the Securities Commission has banned some contributory mortgage companies from being involved. Similar problems may emerge from the current raft of high risk fixed interest offerings and the companies that issue them. Often lenders of last resort, such organisations frequently lend at high interest rates to borrowers who do not qualify for bank finance, eg: for property development or other business activities. And this is not always apparent in their promotion to investors.

Investors need to be educated into realising that fixed interest investing does not necessarily rule out high risk – indeed it can be riskier than the sharemarket - and that rates of return on offer may disguise the true risk that they are being asked to undertake. They must understand that there should be a rational relationship between risk and return on all their fixed interest investments.

Attention to asset allocations is paramount

Certainly, fixed interest has a place in a diversified portfolio. However, higher risk fixed interest should comprise a prudent percentage of the total fixed interest weighting only. And it should be adequately diversified over a range of issues. As a rule of thumb, no more should be invested in any one higher risk fixed interest offering than the investor can afford to lose without compromising long-term quality of life.

As always, follow the simple rules of needs analysis, rational portfolio construction and diversification.