We are told by most financial commentators to pay off our mortgages as fast as we can. It does not matter if you are a business person, salary or wage earner, you will be told the same.

You might be earning more, have had a good year, received an inheritance,  or had a windfall, it does not matter. If have some surplus money, you will hear the same story again – reduce your mortgage, and in theory this is the correct advice.

However, what about building up an emergency fund ? There are good reasons to do so, and  all too often this is overlooked by New Zealanders.

If you were to build up an emergency fund, you would have room to move in the midst of a financial crisis, or tough times, and have more flexibility to keep the bank (or other creditors) off your back.

It is usually quite easy to borrow money when we have secure jobs / normal health, but almost impossible to borrow if things are bad e.g. if we are made redundant , cannot work, are ill, or have had a bad accident. 

 Remember  “a bank is an organization that will lend you an umbrella when the sun is shining, but they will want the umbrella back when it starts to rain.”

There can be many causes of an emergency:

Global recession

 For all the reasons given above, it would be very wise to build up an emergency fund.

Dead money vs. an asset

We cover a lot of risks using life, fire, and general insurances, but the premiums are   “dead” money that you don’t get back, and all too often insurances often do not cover the emergencies that arise.

Most life insurances nowadays are term life, where the premiums increase with age, and rise  very sharply  from around age 55. By building up an emergency fund, you gradually eliminate the need and eventually the cost of such insurances.

Hence your emergency fund is an asset.

How much should be in your emergency fund ?

It is impossible to come up with precise figures since you cannot know the size and nature of a future emergency. The rule of thumb I was taught in NZ  back in 1991 was 3 to 6 months income.

Obviously the more debt you have the more your emergency fund should have in it.

Rocket science is not needed here though, and any amount is better than none. Getting started is the most important step!

In the USA they recommend everyone keeps 8 months income in emergency funds. Given the extent of the  credit crunch in the USA, 8 months would have barely been enough for a lot of people.

Liquidity (access to money)

Emergency funds need to be liquid  – they must be easily accessed. There is not much point having an emergency fund unless it is readily available with say 2 weeks.

How can you build an emergency fund ?

If cash flow permits, set up an automatic payment system and put the funds in monthly.

Or allow for contributions to it in your cash flow planning.

As always, seek a balance between debt repayment and living today as well.

Where not to put it

The first consideration is not in the bank where you have your mortgage. Emergency funds should be as far away from your bank manager’s control as you can get. If you miss a mortgage payment, the bank can move money  from one of your accounts to another without even consulting you.

 It needs to be under your control and preferably your bank should not even know you have it.

Rental property, beach houses, baches, forestry, and commercial buildings are not suitable as emergency funds either as they are not  liquid. Money from these assets can take months to unlock (even years sometimes).  

Nor should it be all invested in shares, since Murphy’s law says they are all too likely to be down 10%, 20% or even 30% at the time you need the money.

None of these assets are suitable as emergency funds.

Where should emergency money be invested  ?

Hopefully you will never need the money for an emergency, and so it should be invested, but in a conservative place. Ideally it would be invested in a conservative diversified portfolio, with a portion offshore.

If it is invested, over time it should grow, and if it is never needed, it will become part of your retirement funding.

New Zealand is a tiny economy and is not particularly well diversified. Further, the New Zealand economy is highly vulnerable to earthquakes, imported diseases and pests. We have already had the Christchurch earthquakes, and the PSA disease in Te Puke’s kiwifruit orchards.

NZ is will continue to be at risk of imported  pests / diseases that might attack  our animals, orchards,  crops,  or  forestry.  In the event that New Zealand’s economy takes a big hit for one reason or another, it is likely that the New Zealand dollar would drop sharply.

 If this eventuates, the value of your offshore emergency funds would be maintained.

What sort of investments is recommended?

A highly diversified conservative portfolio of about 75% in bonds and 25% in shares is suitable.

The bonds should be A rated or better, and the shares in the right kind of share fund, on & offshore.

The correct diversification dramatically reduces risk too. 

Bonds over many years have paid 1% to 3% better than short-term bank deposits.

Shares have had a bad patch recently but over the longer term shares have out- performed bonds by 3% to 5%.

Therefore over time returns from a correctly structured conservative portfolio over the medium to long term are likely to be about 2%  pa. higher than bank rates.

Involvement

It is best to ‘stick to your knitting’ and do the things that you are good at doing.  Therefore, you may  be better off to use an AFA (Authorized Financial Adviser) rather than trying to pick good bonds and shares yourself.

Summary

Get started, even a small emergency fund is better than no emergency fund

Remember it is an asset, not an expense/cost

Always keep it well away from the bank where you have your mortgage

Make sure you can access the funds within 14 days

Make sure it is controlled by you, no one else

Invest a good portion of it offshore to help counter any nasty downturn or disaster in NZ

Review your other affairs and  insurances regularly so that the likelihood of needing your emergency fund is kept to a minimum

If your emergency funds are never needed, they will become part of your retirement funds

 This article was supplied by Alan Clarke who is the author of  “Retire Richer.”   Alan is an Authorised Financial Adviser (AFA) and his disclosure statement is available on request and free of charge.

“Money isn’t the most important thing in life, but it’s reasonably close to oxygen on the gotta have it scale.” -  Zig Ziglar 

Asset Class Investing – a method that you can rely on

You cannot get anywhere without savings and an investment method that you can rely on.  You need to get your money working properly for you, so you can eventually switch from working for money, to getting your money  working  for you (passive income). 

For retired people the same applies except that now it is also about making your money go a bit further, and also lasting longer than you do.

The book contains an investment section that explains investments that do work, and why 80% of investors, share brokers and fund managers are on the wrong track.

Asset class investing can help you be just that much richer than you might have been.

 The 22 big mistakes that people often make

Over the  past 24 years we have observed  people making BIG mistakes  that prevent them from getting ahead while still working. 

Even worse we have seen retired people make some grave errors that have really hurt their standard of living in retirement (not just investment mistakes either).

Most of these mistakes are easily avoided; if you know what they are (they’re in the book).

Maybe you can also eliminate them if you seek advice from an AFA – read on.

 What is an AFA ?

An AFA is an Authorized Financial Adviser. This is a new license issued by the Securities Commission and means the adviser is appropriately experienced, qualified, and must act in accordance with a new Code of Conduct.

However not all AFA’s are independent, as some advisers will still take commissions, or may be on some sort of bonus to sell their employers products. The book explains why you should look for an independent AFA who does not take commission or bonuses. 

 How to choose a Caravan or Campervan on a larger or smaller budget

Any book about money should also include how to have some fun with the money you have worked hard for. Hence the book has a section on one of the most popular leisure activities in NZ . It discusses the advantages and disadvantages of each type of motor home and caravan, including all the options from $5,000 and $500,000.

There are quite a few things you should know before you buy one, so that your travels are fun, simple and easy.  There are also tips on a cheap way to test a campervan before you buy too.  

Leisure 101 (free)

Most travel guides tell you a long list of things you can do in NZ, but so many of them cost $50, $100 or more. If you want to take an extended trip around NZ, you will need a list of things to do that are free.  

In the book we have compiled also to 101 free things to do in NZ so you can extend your trip and still have lots of fun things to do.

Property Investments & Tax changes – where to now?

The government is concerned that too much money is being borrowed in NZ to buy investment property and that it is hurting the NZ economy.  Consequently the government recently changed some tax rules and made property investment less attractive.  

What does this mean for investors & property prices in general ?   This issue is discussed in the book.

The 18 BIG mistakes that retired people make, and how to avoid them

Over 24 years, we have seen about 18 BIG mistakes that retired people make that can really hurt (not just investment mistakes either).  Most of these mistakes are not well known or visible either, since people have their pride and usually don’t tell anyone about them.   These mistakes are easily avoided,  and they are all in the book.

Lending money to your children – good and bad ways

Helping our children is what we all do, but we have seen some sad cases where this has gone terribly wrong, and left the parents finances in a mess.

In the book we discuss some things to think over before you do this, especially as it can wreck your finances and also family harmony.

The 17 BIG mistakes that people age 25 to 65 make, and how to avoid them

Over 24 years, we have seen about 17 BIG mistakes that people who are working make. These mistakes stop them getting ahead today, tomorrow, and later on i.e.  arriving at retirement ill-prepared. All too often they cannot afford to retire at all.

Most of these mistakes are easily avoided, if you know what they are (they’re  in the book).

Kiwisaver – Marvelous or Mediocre – should you be in it?

Everyone under the age of 65 can join, and most of us should.  There are some exceptions but overall Kiwisaver is attractive   – the government  currently give you $1,000 to start off, and put in $20 per week if you put in $20 per week – that is a 100% return! You don’t have to be working either. 

Some people don’t realize they can join and some are the wrong investment fund.   Pay attention to Kiwisaver, it is worth it.  

How to eat your house

As people get older, they sometimes find they have a lot of money tied up in their houses, and not enough invested  – not enough income .  

How do you unlock this money? Can you unlock this money?  This is a big issue and is well covered in the book.

Retirement Villages

There are quite a few things to consider before you buy a unit in a retirement village, and you should get independent legal advice too.   Also should you move closer to family, and away from friends?  Lots of issues to consider before you make a move.

Investment Diversification – what it really means !

Diversification of investments is the number one step to success.  Real diversification means investing across property, cash, bonds, and shares, both in NZ & offshore. 

Note that the bonds need to be of high quality, and the shares in the right type of share fund (asset class is best).

Real diversification also means not having too much in any one of these sectors. Since this is so important, it is well and truly covered in the book.  

Rest home fees- how do they work & who pays?

About 1 in 10 people eventually go into a rest home, and let’s hope that’s not you. However it might be, or it might be one of your parents that need to. This is not an issue to get overly concerned about, and certainly not a reason to “get rid of money” as some people do. 

The book reveals some steps to take that are sensible. In addition, rest home subsidies start at  new higher limits, so rest home fees will not completely disinherit your children either.

Health – what the food industry don’t want you to know!

The author has recently lost 15 kg and along the way found out about some myths in the diet and food industry that most of us need to know. Most diets don’t work because the food is awful or too restricted, and low fat foods can be simply a big con – find out why in Chapter 11.

Family Trusts – are they worth the costs & complexity?

Family trusts are not free and they often cost more to set up and run than the benefits that  might come from having one.

We have a simple test to work out if you should have a family trust or not. 

How your children can “cheat” the banks out of $400,000 in mortgage interest

Most young people today borrow $300,000 to buy their first home and end up paying the banks around $400,000 in mortgage interest. This can be avoided, or at least dramatically reduced. 

It takes some planning and some forethought, but it can be done.  In the book we illustrate a number of ways to do this.

How to avoid burn out while still working

A common problem in NZ is burnout from working. This often leads to ill health, lack of retirement planning, and many other undesirable side effects.

This can be managed and indeed have a wide range of positive outcomes.  We discuss this important subject in the book.

 Life Insurance (dead money) vs. savings

Life insurance is often misunderstood – too many people are either poorly covered, or wasting money on premiums that would be better directed to savings and investments instead.

People often pay more attention to their holiday plans than this important subject  – review your insurances often -  start by reading the book – maybe you can save on premiums now and start  saving/ investing  the money  instead.  Savings plans that work are in the book.

Arthritis

Two years ago the author started taking a  simple homeopathic remedy and since then has had no colds or flu at all – not even a sniff.  And this remedy was recommended by a  health professional too !

But the real BONUS was the remedy, combined with fish oil and a low carb  diet, has also dramatically  improved the arthritis in my hands  -  an unexpected but very welcome side effect.  See chapter 11 in the book.

How to get the book

 Go to www.retirericher.co.nz & buy it on line

“Most people would do well to have some property, but not too much, some cash but not too much, some bonds but not too much, and some shares but not too much.

The bonds should be of high quality and the shares should be in the right type of share  fund. Both bonds and shares should be on and offshore, and widely diversified.”

One could debate this for a week of course, (we did not at the BBQ) but in summary;

Property

Not too much, just look at the Christchurch situation. In addition think about the removal of depreciation tax deductions for property investors, the Global Credit Crunch, & banks looking for bigger deposits.

Add the fact that people are reluctant to borrow heavily to buy property nowadays, and it seems pretty likely that property will be very slow for a long time. Remember too that property is not liquid, as you cannot get cash out of it in a hurry.

Cash

Not too much as cash earns very little interest, especially after tax; however it is safe and available at short notice. When things are bleak and you need money in a hurry, cash is king.

I note that Suzie Orman on CNBC recommends people in the USA keep the equivalent of 8 months income in emergency cash reserves – probably good advice.

Bonds

Over many years bonds have outperformed cash by about 1% to 3%. However not all bonds are equal, and they range from almost no risk down to junk.

It is important to stick to the high quality end and diversify widely, both in NZ and offshore.

Shares

Shares over time outperform bonds by about 3% to 5%, but it takes time and you must have the right type of share fund – asset class funds such as DFA are superior.  The wrong type of shares are those which are not well diversified, and those where someone is stock picking or forecasting – it does not work .

That is the conclusion reached over many years of research by Eugene Fama, winner of the Onassis prize for services to global finance in 2009.

Liquidity

Cash, bonds and shares are all liquid too, meaning you can access cash at short notice too, something you cannot do with property.

The BBQ food was ready by this time so  I concluded with;

“If you spread your money around like this, you will make good money when things are good*, and you will also survive any bad times pretty well too.”

* Historically share markets have had many more good years than bad years.

Disclaimer – this publication has been prepared for your general information. Whilst all care has been taken in the preparation of this publication, no warranty is given as to the accuracy of the information and no responsibility is taken for errors or omission.  Alan Clarke Financial Services Ltd will provide you with an investment disclosure document at no cost before offering you any specific advice.

If anything in this world is well and truly misunderstood it is shares but, in fact, they a very good producer of investment returns. My lecturer in financial planning taught us, correctly, that shares are the “engine room” of any investment portfolio.

When you invest in shares you will be rewarded (nice word), for taking the risk, provided you take the key steps:

Invest in the right type of share fund.

Average in (buy some now and some later). 

Rebalance regularly.

Be disciplined – stick to your plan.

Give it time – patience is needed. 

There are Four Ways to Buy Shares

1.  Direct

Buying a dozen or so individual shares is known as direct investing. This approach poses the usual problem – stock picking is a difficult game whether or not you DIY or use a stockbroker.

And a dozen or so is not nearly diversified enough.

2. Active Managers and Stock Brokers (they choose and manage the shares for you)

They cannot successfully and consistently forecast or pick the right stocks, year in and year out, yet overall costs will typically be 2% to as high as to 3.5% p.a.

“Our stay-put behaviour reflects our view that the stock market serves as a relocation center at which money is moved from the active to the passive.”  Legendary investor Warren Buffett

A recent APRA study in Australia found that, from 2001 to 2006, the average actively managed superannuation fund underperformed the index by 0.9% p.a.

Regardless of all their expertise, the professional fund managers and stock brokers were not able to outperform the index.   

3.  Index Funds (passive)

They buy all the shares in the market so are not forecasting or stock picking, do not need expensive managers, and so have very low management expense ratios (MER’s) and costs.

Index funds are well liked  e.g.  If you held the S & P from 1987 to 2007 you got 11.8% p.a. – pretty good.

Billions of dollars are invested in index funds all around the world.

4.   Asset Class Investing (ACI)

An enhanced method of index or passive investing. 

Asset class investing takes the good parts of index fund investing, still at low cost, and improves on the index model  –  sophisticated yet beautifully simple.

You can rely on asset class funds to perform as well as, or better than, the index consistently, year in, year out.

“Out of intense complexities, intense simplicities emerge.”  - Winston Churchill

What the Experts Say

Active managers seldom outperform the index whereas asset class funds regularly do.

Remember that asset class funds are in effect sophisticated index funds.

  “Only 4%  of active funds beat the index by a scant margin of 0.6 percent p.a., while  96% of active funds fall short of the index by an average of  4.8% p.a.” – David Swensen, Chief Investment Officer, Yale University Endowment Fund.

 “The only value of stock forecasters is to make fortune-tellers look good.” - Legendary investor Warren Buffet.

 “Our stay-put behaviour reflects our view that the stock market serves as a relocation center at which money is moved from the active to the passive.” – Warren Buffett.

 “The road to financial perdition begins with a call to your broker who claims to be able to beat the markets.” – Daniel R. Solin, author.

 “What is the best investment for the average investor? Thorley agreed with Odean: index funds.” -Thorley and Odean are professors who study the market.

 “Index funds have regularly produced rates of return exceeding those of active managers by close to 2 percentage points. Active management as a whole cannot achieve gross returns exceeding the market index an  must, on average, under perform the index by the amount of their expense and transaction costs disadvantages.” – Burton G. Malkiel, author of “A Random Walk Down Wall Street”.

 “Even fans of actively managed funds often concede that most other investors would be better off in index funds. But buoyed by abundant self-confidence, these folks aren’t about to give up on actively managed funds themselves. A tad delusional?  I think so. ‘Picking the best-performing funds is like trying to predict the dice before you roll them down the craps table,’ says an investment adviser in Boca Raton, FL. ‘I can’t do it. The public can’t do it.’” Paul Samuelson, Economist, Nobel Laureate.

What Asset Class Investing Can Do

Asset class investing is based on rigorous academic research, the science of capital markets, and decades of research. 

An asset class portfolio incorporating bonds and shares allows you to construct an efficient, lower cost, diversified portfolio that will not let you down.

The chance of a product failure is virtually eliminated, since the bonds are A rated or better, and both bonds and shares are widely diversified.

What Asset Class Investing Can’t Do

It cannot eliminate volatility, as investment markets will always have their ups and downs, but remember (historically at least) markets have always had a lot more ups than downs.

In the US stock market since 1926:

• The average bull market ran for 1581 days and gained 244% 

        (a “bull market” means positive and upward)

• The average bear market lasted  452 days and lost  -37%

        (a “bear” market means negative and downward)

You will still have to put up with volatility but, (historically) again, every time markets have fallen they have gone on to new highs.  Patience is the key and will usually be rewarded.

An Asset Class Portfolio Will Serve You Well Over Time

An asset class portfolio will serve you very well over time. It may go up and down sometimes but it will not go away.  

Asset class portfolios are mainly available from independent advisers.

Asset class portfolios are liquid so access to cash is easy.

If income is needed, there are several  “user friendly” options.

Savers can add money monthly or in lump sums.

 Disclaimer – this publication has been prepared for your general information. Whilst all care has been taken in the preparation of this publication, no warranty is given as to the accuracy of the information and no responsibility is taken  for errors or omission. You should seek the personal advice of your financial adviser before taking any  action in relation to the matters dealt with in this publication.

Total return 10% Income + 3% capital gain = 13%

Income

Rental income since the  credit crunch is likely to be a little less,  due to less tenant demand, and also due to the reduction in depreciation that can now be claimed.

Rental yields on commercial property were  typically 8% to 12% depending on location, the type of tenant, length of lease and many other factors,

For example Westpac bank on a 20 year lease might yield 8%.  A small business on a 2 year lease in a rural town might be paying 12%.  However many owners would prefer Westpac as a tenant for obvious reasons.

Since the credit crunch this yield range is likely to be reduced down a little to 7% to 11%.

Capital Gain

The global credit crunch has reduced tenant demand, and property investors are  now less likely  to  borrow a lot of money to buy property. Less tenant and less buyer demand translates into  weaker prices and  a less likelihood of capital gains in the near future.

Future Total returns

Overall there will be less demand, so capital gains may not eventuate in the property market at all for several years.

If capital gain is going to be absent, then investors would be wise to focus on yield.

The typical yield on a residential rental property is around 3%  to  5% pa.

The typical yield of commercial property is around 7% to 11% pa.

Diversification

Diversification is essential. If you diversity across bonds, property and shares on and offshore, you will never go far wrong.

The recent earthquake in Christchurch is a sad example. Imagine if you had all your money tied up in say 3 commercial properties in Christchurch. One might be badly damaged, one slightly dammed, and one OK.

You would most probably not be able to collect rent on the badly damaged building, and even with the best insurance policy, you would be out of pocket by up to 33% in lost rent.  In addition  you would possibly miss out on 10% to 20% in capital gain potential over quite a few years.

Diversification & NZ Risks

If you have all your money tied up in NZ, you are at risk because you are fully exposed to the NZ economy. It is very narrow and could easily be de-railed if we import a major “nasty” such as foot & mouth disease.

Diversification & Liquidity risk

Everyone needs liquidity or access to cash as emergencies do arise. Property is illiquid in that you usually cannot get cash out of it until you sell it, which can take several months or even longer.

Bonds and shares are usually liquid which helps.  However  we recommend everyone also holds some cash handy for emergencies.

Diversification & Tenant risk

Demand is lower from tenants – just look around locally and count the number of vacant commercial properties – the number is surprisingly high.

But beware, even big name tenants move on. I remember seeing a big building touted widely with the IRD as tenant.  Six years later the IRD’s lease expired and they moved to bigger more modern premises.

Six years can come around quickly and an empty commercial building has a very low resale value.

If the owner/investor  has borrowings, then an empty building is an even bigger risk and headache – who is going to pay the mortgage?

How much property do you have already?

Many Kiwis have  already have a lot of property  by owning a nice home and sometimes a rental and beach house as well. If you are a typical Kiwi, probably 50% to 80% of your total assets are tied up in property already.

All property values are affected by the NZ economy & events one way or other, so if you are heavily  into NZ property, even if it is in different towns and different types, you  may not be as diversified as you    think.

Morningstar Research recommend that most NZ investors  who own a decent home or more should  not put more than 10% of their money into property investments.

The Best way

The best way to invest in commercial property in NZ is to buy shares in the well known listed property trusts (LPT’s) via the NZ share market.

By investing across the following four listed property companies (LPT’s), you will be widely diversified across the four main property types, and across dozens of buildings in each fund.

You can invest as little as $1000 into each fund, but $5,000 each or more would be more realistic and efficient.

ING Healthcare Property Trust – owns hospitals and healthcare centres.

Kiwi Income Property Trust -  mainly owns shopping malls plus some office buildings.

Property for Industry – owns factories and warehouses.

AMP Office Trust – owns office buildings.

The trusts pay a dividend (the rent) of about   7% to 11% pa. , and are listed on the NZ share market so they can be sold at any time (liquid).

These funds are all traded daily on the NZ share market so are easy to buy or sell, and all are well diversified.

These are four well known companies, but note this is not a stock picking or forecasting method  – simply diversifying across the property market place since no one can pick the right property stocks year in year out.

Global Property

For global property diversification, a small allocation to the DFA Global Real Estate fund fits in well  -   spread across about 240 listed property trusts (LPT’s)  around the world.

Warning – Avoid Property Syndicates

A few of these are still around and they are can look good (are cleverly marketed).  You should always remember to check :

“Who is promoting this to me and how are they getting paid?”

All too often they are getting commission if you invest. It may be that selling you the investment is good for them, but it may not be the best for you.

They often look good, with one or two big name tenants, but in fact are nearly always lacking in diversification. See the notes above about the IRD moving on when their lease expired.

Syndicates are not usually liquid, and you can only get out if you can sell your investment to someone else.

Syndicates can have high front end costs, for advertising, legal fees, commission to the sales people, and so on.

We have seen costs as high as 9% over and above the purchase price, and of course you will make no capital gain until the property has risen in value more than the front end costs.  In a low capital gain environment, this could be many years away.

A lot of money has been lost in syndicates in NZ over the past decade.

Generally speaking syndicates only suit small groups of experienced investors who can work closely together.

Most  syndicates fail our 7 point checklist

The 7 Point Checklist to Use Before Investing in Property

• Diversify across the four main property sectors
• If you own substantial property already, do not put more than 10% of your total assets into investment property
• Focus on yield -  recognise that capital gains might be muted or even absent for several years
• Do not try and pick the “right” fund – stock picking is a futile exercise
• Do not try and forecast which property sector will out-perform over the next few years – forecasting is a futile exercise
• Remember that property is illiquid and access to cash can take months or longer
• Avoid syndicates unless you are a very experienced investor

Nearly every government, company and State Owned Enterprise (SOE) in NZ and around the world borrows money. This is often to develop and expand, and sometimes to refinance existing debt.  Huge amounts are involved, but often go unnoticed as many of the loans are made behind the scenes by merchant banks and other institutions.  These loans are  commonly  known as bonds.

Most bonds are issued for 5 years at a  fixed rate, usually at a margin over bank rates, depending on the quality.  There are other bonds that reset the interest rate annually, and some are perpetual and never mature. Unless you really know the bond market well, it is better  to  stick to five year bonds that pay a fixed rate, and have a known maturity date.

Good bonds can be bought and can be sold at any time,  often a  useful  feature.

Ratings might be AAA, AA, A, BBB, BB or B, and anything higher than BBB  is investment grade.  We prefer  A rated or higher, although some BBB rated bonds can be considered if they are senior debt or State government owned enterprises ( SOE’s) .

Current ratings and interest rates at September 2010.

In 2009 and to a lesser extent in 2010  there have been a lot  of new bonds issues, some good, and some rather   ho-hum.  Since bank rates for 1 year are around  5%,  bonds being issued at 6.5% to 8% are very popular.

Caution – when an investment class becomes very popular, prices can rise too far too fast – read on !

How to buy bonds

Bonds can be bought when issued,  but new issues are not always available.

They can also be bought on the secondary market (from someone else via a broker).

At the moment (September 2010), bank rates are low, new issues of good bonds are scarce, and good bonds on the secondary market are expensive.

Failure Risk

Bonds can fail and recently a few have fallen over, such as Babcock & Brown (which was unrated).  A good rating does not  guarantee a bond, but it is a useful place to start.

Too expensive risk

You can buy good bonds at times when interest rates are low, demand for bonds is high, and pay too much for the bond.

Later on when you need to sell your bond or when it matures, you may get less back than you paid for it.

Other risks

Take a look at who is telling you this or that bond is a good investment.  Bonds often pay commissions to brokers so it may be that the person/broker recommending the bond to you is getting a commission from it if you invest.  Unfortunately this can mean the bond is good for the person selling it to you, but not necessarily good for you.

Always ask the person promoting it  how he gets paid.

An independent adviser who does charges fees and does not take commission is more likely to give you unbiased advice.

We observed some big brokers (who take commissions) recommending every new bond issue in 2009, but they were not all good.

Commissions and investments are not a good combination.

Quality

A key investment rule is to always buy quality investments. The NZ market is small  and you should seek only the highest quality bonds.

If you do,  you will find it hard to get more than four to five  bonds that have a high rating and pay a good interest rate at a fair price.

NZ  Risks & Diversification

NZ is a tiny country and is highly exposed to major catastrophes such as earthquakes, foot-and-mouth disease, and so on.  The recent Christchurch earthquake is a sad reminder of this. If it had been in Auckland…

You should never have all your money in NZ. It is most important that you diversify your investments and have some outside NZ as well.

Diversification – more

To keep risk at its lowest, do not to invest more than 5% of your investment portfolio into any one bond.

Note that bonds usually need a minimum investment of $10,000.

For portfolios over $150,000 it is fairly straightforward to fit in several bonds of $10,000 each.

For portfolios under $150,000,  a $10,000 bond represents more than 5% of the total. In this case it would be better to use a bond fund  which might have some extra fees, but the  diversification will be worth it, even if the return is a little lower.

Diversification – yet  more

In offshore markets there are thousands of bonds and so including an offshore bond fund in your portfolio would be wise. This will add diversification and reduce exposure to the tiny NZ economy.

NZ is has a narrow economy, based mainly on agriculture and tourism. It would only take a single major event to hit NZ companies hard, and you will be hit hard too if all your  investments are in NZ.

If a major event hits NZ, the NZ dollar will fall, and so  offshore investments will rise in value (in NZ$ terms), probably offsetting any losses you might have incurred in NZ.

Don’t try to predict interest rates

Ideally all your bonds would mature at a time when interest rates are high, or at a peak.  If you could time it correctly, you could re-invest  then and lock in high interest rates for several years.

However interest rates are impossible to predict, and so you don’t want all your money maturing at the same time.  A bond portfolio should have differing maturity dates.

E.g. some maturing in 2012, some in 2013, some in 2014, some in 2015 and so on.

Seven things you should know before  investing in bonds

• Bonds are highly sought after and expensive at the moment – beware
• Beware of  advice if the person giving it receives  commissions
• Always  buy quality investments  (look at  the rating and the company itself)
• If you can’t get the quality and number of bonds you want, wait, and be patient
• Make sure your bonds mature on different dates
• Never put all your money into NZ based investments
• Diversify widely on and offshore into bonds, property  and shares

Professor Fama is well known for his work on porfolio theory and asset pricing.  He is also a director of the Dimensional Fund Advisors Inc. (DFA), our chosen investment fund manager.

You can read more articles by Professor Fama on the Fama French Forum website.

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