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Looking for the perfect investment - Part 2

Some questions to ask when looking at fixed interest investments. This is the second of a two-part article.

Monday, January 16th 2006, 8:03AM

How Realistic are these Risks?
"There is no such thing as a free lunch" (Milton Friedman). A higher interest rate is paid on finance company debentures relative to the banks because there are riskier investments. It really is that simple. However, what is the real likelihood of a problem?

In a strong economic period, the risks are muted. While inflation is under control, GDP and other measures of economic activity are high, and the job market is strong with low unemployment, then borrowers can sustain interest rates a few points above the banks, and handle any small rises fairly well.

It is this sort of environment that we have been enjoying. According to Darryl Briggs of Alliance Capital, AXA’s investment management partners, finance companies have been able to make hay while the sun shines. Clouds are gathering that could rain on the parade.

Briggs believes that the New Zealand economy is at a turning point…

"The New Zealand economy has exhibited strong growth over a period where many economies have struggled. The success formula was characterised by migrant inflows, strong housing demand, solid demand and high prices for our exports, relatively tame inflation and relatively low interest rates.

"In recent quarters interest rates have moved to high levels and the currency has stayed high too. Many migrants no longer view New Zealand as their first choice. Inflation looks set to rise to approximately 4%. It seems that it could stay there for a number of quarters.

"The Reserve Bank is supposed to keep inflation in the 1% to 3% range over the medium term. They are likely to ignore the initial breach because much of it is petrol related and this could reverse itself over time. Higher interest rates for longer are the likely result.

"This supports the view that the New Zealand economy could continue to weaken. Alliance Capital expects that the low point for the New Zealand economy could be mid-2006. Its expectation for growth at that point is that the New Zealand economy could be close to recession. Exactly what occurs, depends on a few of the variables that are difficult to forecast (will the drought in Canterbury extend to other regions, for example?).

"Whatever happens, it appears as though things are likely to get worse for the New Zealand economy before they get better."

Clearly the path ahead looks a lot rockier than what we have recently experienced. There will be more finance and property company debt issues that could run into problems. Other types of investment will have problems too, of course. When recession hits, there are fewer places to hide. But with all of these factors in mind, what is the place of fixed interest in an investor’s portfolio?

Julia Harrison, Financial Adviser, of Charter Financial Planning says that Charter use a two-pronged approach to selecting suitable fixed interest offerings. The first is working through a quantitative and qualitative assessment process. The second is working with the client to determine their risk profile and developing a laddered (tiered maturity) portfolio, considering exposures to providers, offer type etc. Julia says "We believe it is better to forego a small amount of yield to gain superior security".

Key Questions to ask about a fixed interest investment:

- How strong is the investment company – do they have the standing, history and strength to help protect investors?

- Why is the interest rate this high?

- What is my money being used to finance?

- What is the likely economic scenario from here, and how will the investment companies debtors deal with any forecast problems?

- Would you buy shares in the company?

- What is the level and type of security that sits behind the issue (remember, first-ranking is unlikely to mean the same thing for all investments).

In summary, AXA believes in the key principles of investing – including Diversification, and Advice. Investment markets move in cycles, and there are investment types that are best suited to particular periods of a cycle. Certainly, take advantage of a good investment – but get professional advice. Higher returns only come with higher risks. Know the risks before investing.

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