Fixed Interest

How does it work? Do I know what I have? Is it safe?

When we invest in Cash Based or Fixed Interest type investments these are generally regarded as DEFENSIVE ASSETS in our investment portfolios, whereas shares and property are regarded as GROWTH ASSETS and are considered to be more volatile assets.

The aim of this article is to go deeper into the whole Cash Based or Fixed Interest landscape to cover the various types of investments available to investors and importantly cover the RISK of the various types. In particular as these type of investments are generally regarded as Defensive or Safe investments it is important to highlight the differences and clarify the safeness thereof – so to speak.

Firstly, let us list the various types of Cash and Fixed Interest type investments. For the purposes of this article I have excluded Cash based “Day to Day” bank accounts as they are essentially just transaction accounts.

  • Cash Management Type Accounts
  • Term Deposits
  • Government and Semi Government Bonds
  • Corporate Bonds
  • Mortgage Trusts
  • Hybrids (being a mixture of some of the above)

Fixed Interest Investments – Risk

Secondly, we need to understand the various risks involved in Fixed Interest Type investments. The type of risks can be classified as follows:

  • Interest Rate Risk (including Time)
  • Specific Company or Organisation Risk

For Interest Rate risk this is best explained by an example.

Let’s say Mary invested in a 5-year Term Deposit of $10,000 at 4% per annum interest. Then Mary would receive $400 every year for 5 years, then receive her $10,000 investment capital back at the end of the 5 years.

Again let us assume that at the time of Mary investing the CPI rate (inflation) was running at about 2% per annum. Let us also assume that after say 2.5 years (half way through) CPI rates had risen to 3% per annum and new 5 year term deposits were now paying 5% per annum interest.

If Mary was to “cash in” or close the Term Deposit half way through its term (perhaps to seek a better current rate) then the provider would effectively value the Term Deposit at the time as follows:

Mary would receive a “pay out” value of approximately $9,750 being the “reduced value” of the Term Deposit half way through its term.

Conversely, if the CPI reduced and interest rates available also reduced over the same 2.5 years then the situation would be as follows:

Mary would receive an increased “pay out” value of approximately $10,250 being the “increased value” of the Term Deposit half way through its term.

Of course if Mary does nothing then the original Term Deposit stands with interest paid each year to maturity when the original capital invested is returned to Mary.

The same principle applies to other forms of Fixed Interest such as Government Bonds, Semi Government Bonds and Corporate Bonds where movements in CPI and Interest Rates available have an effect on the value at any one time.

Specific Company Risk

In addition to Interest Rate risk there is the usual specific company/organisation risk (just like investing in shares) relative to the strength of the company or organisation issuing the Bond.

This market is essentially companies wanting more capital and therefore issuing Corporate Bonds (of varying duration, size and risk) to investors. Government and Semi Government organisations also issue Bonds to investors to mainly fund their Budget deficits. Like investing in a share of a company it is important to understand the risk “Is my Capital safe?” in comparison to the interest rate being provided – Am I being compensated with a good rate of return for the perceived or real risk involved?

Obviously it would be fair to assume that a Commonwealth Government Bond would be “Safer” than just an ordinary company bond. Bond rates for government bonds would be on average lower for the perceived or real lower risk of return of the original capital invested.

Mortgage Type Trusts

So often we see an advertisement that says Fixed Term investment (the wording for the sake of marketing really) which might be paying say 6% per annum interest. This rate might be considered great compared to the current Term Deposit rates on offer of say 4% per annum.

We therefore jump in, but is this really a Term Deposit type investment like those offered by banks etc.? The marketing implies Fixed Term but the question we should ask ourselves is why is it 2% higher than the going Term Deposit and/or Government Bond rates on offer.

In view of this we need to look further and ask the following questions:

  • What type of assets are actually backing this 6% return?
  • Why is this rate on offer so much higher?
  • Is it as safe as a Term Deposit or Government Bond?

Invariably these types of investments are able to offer the higher return because there is more risk involved than say investing in a Term Deposit or Government Bond.

It is important that a good percentage of monies will be invested into Property based investments (could be a mix of commercial/retail/industrial/residential properties or just one type).

Thus the higher yield is able to be paid from higher rents being received into the Mortgage Type Trusts than those available on term deposits/bonds etc.

Therefore, you would essentially have some Growth Based Assets in an investment which may generally be regarded as a Defensive type investment.

Because property values can change at a whim and therefore people owning the properties backing these investments may decide to liquidate, then you can get a run of property sales. If there is a larger than expected run of property sales with perhaps lesser values (some fire sales so to speak) then this will have to be reflected in less liquidity in the overall Trust (to meet investors interest payments) as well as a reduction in the overall capital value of the Trust.

Investors could then experience a freeze on accessing their capital and/or reduced interest payments or a complete closure of the overall Trust with a reduced capital payout of original investment monies. Well known examples were Pyramid and Banksia where people were attracted to higher interest rate returns and were surprised by the reduced capital outcomes.

The bottom line for investing in Fixed Interest Type investments is that we need to ask the following questions

  • How do I view short/medium and long term rates?
  • How do I view the direction of the CPI?
  • What is the makeup of my Defensive Assets and the duration of the fixed interest investments that I hold?
  • What is the make-up of the assets backing the actual investments?

Awareness is the key so there are no future surprises.

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