This article was published on 13 May 2008. Some information may be out of date.

Safe haven for nervous investors

Spooked by the Blue Chip, Feltex and finance company collapses, a growing number of New Zealanders are joining the “flight to quality” by buying government bonds or their little brothers, Kiwi Bonds.

Government bonds sell for around $10,000, while the minimum for Kiwi Bonds is $1,000. They work rather like bank term deposits. You receive regular interest payments and, at the end of the term, the government repays you.

The only thing that can go wrong is that the government goes broke, which seems nigh on impossible.

The downside is that interest rates are generally lower than on bank term deposits. Still, they’re well above inflation.

At the time of writing, yields on government bonds ranged from 7.85 per cent on bonds that mature on July 15 down to 6.42 per cent on bonds that mature in December 2017. The interest on Kiwi Bonds is 7.5 percent for six-month bonds, 7 per cent for one-year bonds and 6.75 per cent for two-year bonds.

Why do I use the word “yield” on the government bonds? It stems from the fact that, unlike bank term deposits, you can sell the bonds at any time in a market run by the stock exchange.

Let’s say you bought a $10,000 bond that pays 7 per cent, or $700 a year. Several years later you want to sell it. But interest rates have risen, so nobody wants your bond — unless you sell it for less than $10,000.

If you sell for $9,000, the buyer will receive $700 a year on the $9,000 purchase. That’s more than 7 per cent. What’s more, if the buyer holds the bond to maturity, he or she will get back $10,000 — an extra $1,000 over the purchase price. That is all calculated into a yield considerably higher than 7 per cent — which is acceptable in the new higher rate environment.

What if, when you want to sell, interest rates had fallen? Your bond would look attractive, and a buyer might be willing to pay $11,000 for it. That buyer then receives $700 a year on $11,000 — less than 7 per cent. And at maturity the buyer will get only $10,000. This all amounts to a yield well below 7 per cent — acceptable in a lower rate environment.

To summarise, the yield is like an interest rate, but it takes into account changing bond values as interest rates change.

The trouble with explaining this is that it confuses or worries some people unnecessarily. If you hold a government bond to maturity, you will always get back its face value, regardless of what has happened to interest rates.

And that’s what most New Zealand buyers of government bonds do. But it’s nice to know that you could sell somewhere along the way if you had to.

There is no similar market for Kiwi Bonds. You can request early repayment, but your interest will drop two percentage points. Anyway, the terms are shorter.

Note that on both government bonds and Kiwi Bonds interest rates are higher for short terms than longer terms. But shorter terms aren’t necessarily better.

When the rate structure is like that it means market interest rates are expected to fall. With Kiwi Bonds, for example, you might be better off getting 6.75 per cent for two years than getting 7.5 per cent for six months, only to find the rate considerably lower when you go to reinvest.

For information or to buy government bonds, see a stockbroker. Kiwi Bonds can be bought through banks, sharebrokers and some accountants, lawyers and investment advisers.

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Mary Holm is a freelance journalist, a director of Financial Services Complaints Ltd (FSCL), a seminar presenter and a bestselling author on personal finance. From 2011 to 2019 she was a founding director of the Financial Markets Authority. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it.