Agony Aunt: Bonds a liquid option

Dear Janine,

I have a sum of money in the bank and have noticed that banks such as the BNZ are issuing bonds in which I could invest. The odd thing is that the interest rates are lower than the rates they will pay on a term deposit for the same length of time. Why on earth would I invest in a bond, if the rate is lower? It seems like the same sort of investment to me.

Can you explain?

ANSWER:

It's a bird. It's a plane. No, it's a confusing financial product. Unfortunately, I couldn't bring myself to describe a bond as Superman. They're just not exciting enough. That's probably a relief, because when it comes to fixed interest, we want certainty, stability and simplicity, not a bank manager in a pair of red tights tempting us to choose between their bonds and deposits.

Term deposits and bonds do indeed look the same. They promise a fixed rate of interest, for a fixed period of time, and our money will be repaid in full at maturity. With both, we take credit risk on the issuer. Although for the last couple of years, if anything went wrong, the government promised to act as a generous superhero, to the tune of $1 million for each investor under the deposit guarantee scheme.

This safety net is due to expire in a couple of months and banks such as ANZ and BNZ say they don't intend to sign back up. It's likely to be because of the cost, which is a shame, since a more sensible scheme protecting amounts up to, say, $50,000 would have been a nice result for small investors.

The one big difference between bonds and term deposits is their liquidity. With a bond, you can sell easily, at a market value and at any time. This is the major reason that some people prefer bonds. Also, the range of issuers is larger than just banks and this gives more diversification of risk.

But here's the catch - you could suffer a capital loss if you sell early. If interest rates have risen, a new investor is stuck with the lower fixed rate paid by your bond. The only way to attract a sale is to offer a discount, which is taken off your original investment. This has the mathematical effect of recalibrating the interest rate to the new market level. Unfortunately, you suffer a capital loss. On the flipside, if rates have fallen, your bond is paying a higher fixed rate and new investors will pay a premium if you sell early, giving a capital gain.

Some investors will buy bonds with no intention of holding them for the full term. They will be taking a punt that interest rates are going to fall in a particular time frame and they are hunting for an expected gain. If they are clever and a bit lucky, they can earn more than just the interest being paid.

To get into this game, you really need a detailed understanding of the interest-rate curve, a view on which parts will steepen or flatten and strong economic views to back your decisions.

It's not for the low-risk investor, because you can suffer losses if you get it wrong.

Back in the real world, most of us have no desire to use bonds in this way. The average investor just wants a fixed income.

It can be a hard decision to tie up your money for five years, the usual length of a new bond issue. Having the ability to sell at a market level, even if you don't think you will need to, can give comfort.

Term deposits, on the other hand, are the dinosaur of the fixed-interest world and their prehistoric nature saddles them with about the same level of flexibility.

That said, they can't be knocked, because they are simple to invest in and you can't suffer a capital loss. The bank can only pinch some of your interest if you need to get out early (a break fee).

For investors who are certain they won't need access to their capital, the threat of a break fee doesn't bother them and they will make their decisions based on where they can get the highest interest rates. The clear drawback is that if you need to break your deposit early and rates have fallen, you will pay a penalty, when true market forces would give bond holders a profit.

Term deposits are often touted as having limits for those who hold large piggy banks, because there might be a $1 million maximum size. I have not seen evidence of this in practice.

Banks are desperate for funding from retail investors and will happily relieve them of deposits larger than $1m, at better than published rates.

The BNZ bond you were referring to has just closed and investors are locked in to a five-year fixed rate of 6.165 per cent. Five-year wholesale deposits are a long way south of this at a miserly 4.50 per cent, and banks are being forced to pay investors about 1.6 per cent more, to attract their money.

At the same time as the BNZ offer, most of the major banks were advertising five-year term deposits at 6.75 per cent, 2.25 per cent more than market rates.

In recent days, these five-year term- deposit rates have begun to fall, with BNZ and ASB being the first to lower theirs, to 6.50 per cent and 6.20 per cent, respectively. Others may follow.

When juggling the bond v deposit decision, it all comes down to picking the investment type that suits your circumstances. I've bought both, but I'm largely in the dinosaur camp, and I've bought five-year deposits, not bonds, because of the difference in rates, but I have no need to sell and don't need the liquidity. We're all different and the market simply provides us with choices.

Janine Starks is a financial commentator with expertise in banking, personal finance and funds management. Opinions in this column represent her personal views. They are general in nature and are not a recommendation, opinion or guidance to any individuals in relation to acquiring or disposing of a financial product. Readers should not rely on these opinions and should always seek specific independent financial advice appropriate to their own individual circumstances.