Interest Rates being offered do not tell the full story

There is a lot more to choosing a term deposit or bond than simply looking for the best interest rate on offer.  No investment is totally risk free.  All investments involve some trade-off between risk and return.  While bonds and bank deposits may be a more secure form of investment than some other asset types, they should not be considered fully secure. 

If you find a fixed interest investment offering returns significantly higher than money in the bank, there will be a good reason for it.  You need to find out just what those reasons are, before you can make an informed decision.  While there is an old saying that higher returns generally mean higher risk, it is not always the case when looking at, for example, some finance company secured debentures.   In our experience, some of the highest risk finance company offerings have had some of the lowest returns compared to others operating within the same market sector.

When looking at a fixed interest investment, in addition to finding out about the term and promised returns, you should ask three main questions: Who will I be lending my money to? What will they use it for? What security or guarantees will I have?

First, who is involved? The higher the credit-worthiness of the borrower, the greater your security.  Once you look beyond the Government, State Owned Enterprises, local authorities and registered banks, you need to be a little bit cautious.  You should ask, for instance, whether the borrower has a credit rating and whether it is from a recognized ratings agency.  The Securities Commission says that if a company has a credit rating, it should make it available to potential investors.  This has come about because some companies had credit ratings and were choosing not to reveal what they were.

Look at what your money will be used for, and ask how the borrower proposes to be in a position to pay you your interest payments and eventually your original capital.  You may face an ethical decision in what your monies will be used for.  Should I lend money to this company, who in turn lends it out at exorbitant interest rates?

With some lending, particularly bonds, the borrower may depend on achieving a certain level of sales in order to meet its investors’ income expectations.  If that sales target isn’t met, investors can be affected.  On the other hand, with government stock, you can reasonably expect your interest payments to be as regular as clockwork, as well as the eventual repayment of your capital.  If for some reason, you sell the investment before maturity, you may make a capital loss if interest rates have risen.

Check to see what securities or guarantees there are. If something is advertised as “guaranteed”, check to see just what this means.  Under law, only a genuine third party can offer a guarantee - the borrower can’t act as its own guarantor.  Just because there may be a guarantor in place, shouldn’t give you peace of mind.  Many a mortgage with a guarantor in place has failed, and when the guarantor is pursued, invariably they cannot meet the borrower’s debts.  

Will your investment be ‘secured’ or ‘unsecured’.  If secured, is it by a first-ranking mortgage? Should something go wrong, remember the unsecured creditors (investors) will be the last to get paid.