Products With Enticing Interest Rates Could Cost You Capital

Sun Herald

Sunday November 7, 2004

DARYL DIXON

What types of fixed-interest products are proving popular?

Mortgage funds and debentures are experiencing enormous inflows. They are backed by mortgages on various types of properties. There are also hybrid securities, preference shares and convertible notes, typically backed by major corporations and with a rate of interest 1 to 3 percentage points higher than the government bond rate.

Are these sorts of investments a good idea?

Most investors don't maximise returns on their lower-risk investments, but in the current market I am worried that some investors are exposed to higher risks than they realise. You really need to look at your situation and investigate the risks, terms and conditions, and see if they all suit your needs.

What is a mortgage product?

These are sold in two forms. First, the open-ended mortgage funds from many big companies such as Colonial First State, Perpetual and Challenger and smaller operators. You usually (but not always) can get in and out of these funds at any time. Second, the "debentures" sold by other mortgage operators that are for fixed periods.

What sort of returns do they make?

The current yields range between 5.5 per cent and 9 per cent.

That sounds great, what are you worried about?

The real issue can be thought of in relation to the underlying investment. These are investments in mortgages on various types of properties in various stages of development. But think of it this way: if a fund is paying you 8 or 9 per cent and taking 1 or 2 per cent as a fee for the manager, the borrowers with the mortgage must be paying 9 to 11 per cent interest. Given that normal residential mortgage rates are about 7 per cent, it helps you appreciate how much higher risk these borrowers are compared with most of us.

Does that mean I shouldn't invest in these products?

Not necessarily, it just means that you should investigate the product thoroughly before investing in it, and make sure you appreciate the risks. If one of the major borrowers from the company were to default, you could instantly lose part of your capital. And the situation could be a lot worse if the company itself went under.

What about the other types of products?

Because these are backed by corporates in various ways, they are extremely complex. For instance, the new international accounting standards and changes to APRA rules have resulted in new preference shares from Adelaide Bank, St George and Santos that have far different terms and conditions than previous issues. They give far more rights to the issuers than similar investments, but investors seem not to have noticed in the way they are pricing them in the market. The key difference is that the investor cannot ask for the investment to be redeemed or converted at any point, whereas previous products usually gave the investor the right of redemption or conversion every five years. The best way to highlight this risk is the example of AMP. When AMP was really suffering in May of 2003, it had two listed fixed-interest securities. One was a reset preference share that gave investors the right of redemption or conversion every five years and the other was an income security which was very similar to many of the new issues. The lowest the reset preference share traded was about $92, whereas the income security dropped as low as $66. Thankfully, AMP survived and both securities returned to their face value of $100, but those who didn't understand the products probably got a very nasty scare at the time.

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© 2004 Sun Herald

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