The amount of money being sought by large New Zealand companies is taking financial markets by storm.
Contact Energy and Fonterra have between them raised $1.3 billion in oversubscribed senior bonds during the past three weeks.
Four more companies are similarly chasing a total of $680 million.
As money becomes harder to find for large corporates, more bonds are expected to be released to the market with buyers eagerly snapping up the 7% to 8% returns as bank deposit rates fall.
Reid Asset Management principal James Reid said it was blatantly obvious that many fixed interest investors were being wooed into investing in the corporate bond market on the basis that bonds were an alternative to cash and term deposits.
"It is extremely important that investors recognise that bonds are completely different instruments and that they have unique characteristics when compared to term deposits.
"They must not be seen as a complete substitute, but rather should be treated as an instrument that can be used to compliment cash and term deposits in an investment portfolio," he said.
Peter Smith Financial Services principal Peter Smith echoed Mr Reid's thoughts but added a chilling warning for investors.
"The frenzy in bonds is happening along the same lines as the failed finance companies even though it is a different class of investment.
"People are putting too much money into the bonds without reading the fine print."
It appeared as if Contact had resurrected an old formula which decreed that if it did not pay interest, it was not regarded as being in arrears.
Contact also listed several ways where it would or could not pay interest, he said.
"People see the rate and rush right into it and then their investment is locked in for a few years."
Although the bonds are tradeable, Mr Smith recounted a story of a client who wanted money "desperately" and had to sell out of bonds at a 30% discount because of the market downturn.
It was difficult to sell in these times and investors with bonds who wanted to quit them would need to accept a 10% to 15% discount, he said.
Mr Reid issued a list of checkpoints for investors to consider when buying bonds.
Investors should be selective with regards to the company and should not rely on the name of the company alone. Companies changed and while reputation was important, it should not be relied upon solely when making an investment decision.
Bonds that were specified as having a senior ranking should be given a priority. Companies offering subordinated debt should generally be left to those sophisticated investors who understood the risk.
Investors who were not sophisticated must maintain a staggered approach to the maturity profile of their fixed interest portfolios.
"It is simply wrong to place all of your funds in five-year bonds on the basis that the interest rate appears good. Who knows where interest rates might be in five years time and who knows what opportunities might come about prior to maturity. Your personal position may change and should funds be required, bonds may have to be sold at a loss," Mr Reid said.
"There is a good reason that a term deposit might offer a yield of 4.5% and a corporate bond 8.5%. In simple terms it comes down to one word - risk. That risk might pertain to the time the money is invested for.
"It pays not to forget that term deposits with Treasury-approved institutions have approximately 18 months remaining in the deposit scheme."
That meant that the Government guaranteed both the capital and income on that investment. The current plethora of capital bonds provided no such guarantees, he said.
People should think twice when investing seemed easy. Everyone should be aware that returns were difficult to come by in the current environment.
When re-investing at a higher interest rate, investors should think about why that was the case and what reasons warranted the higher rate offered by companies, Mr Reid said.
Was the rate being offered commensurate with the higher level of risk associated with investing in that entity and the duration of the bond?
If bonds were held as part of a managed fund, investors must realise that should longer term interest rates rise, the value of their investment would drop.
Investors who held unit trusts would be most affected given that their investments were "marked to market". While an investment in a bond fund should have been a good investment over the past 12 months, investors should now be reconsidering their exposure given the potential for longer term interest rates to rise.
"Under no circumstances should a conservative investor be investing in a bond fund based on recent performance. It is highly likely that bonds could underperform as an asset class over coming years," Mr Reid said.
Mr Smith said that the degree of protection offered by investing in a managed fund - particularly unit trusts - was being misunderstood.
A managed fund was a pooled investment where investors hired the services of a manager to manage their money.
Pooling investments gave a wider scope to investing with greater buying power with small amounts of money. It was possible to be part of large funds of many millions of dollars for from as little as $100 of regular savings a month.
"Investing in such a manner also reduces the risk of investment failure in a company or particular investment vehicle. Safety in numbers reduces risk where one or two failures in 20 to 30 investment products within the managed fund should prevent all from declining," he said.
Each unit trust had a unique trust deed setting out the investment sectors in which the unit trust would operate. It also determined the asset allocation of each type of asset class, such as fixed interest, shares or property, and the proportion of New Zealand to overseas assets.
The trustee managed the trust deed, ensuring the managers did their job correctly within the terms set.
"Having said that, the trustees haven't been too flash in some of the finance companies," Mr Smith said.
Currently, there were several managed funds - particularly mortgage funds - that were frozen to protect all investors. The fund manager did not have access to the funds to use as they saw fit. They were employed by the unit holders as managers only.
Under the Unit Trusts Act 1960, the trustee had the power to sack the manager and appoint another if they saw reason to do so, he said. Prime reasons for a sacking would be breaching the trust deed, such as investing in sectors not defined by the deed.
"If investors hear a report that a fund from AMP, AXA or ING is frozen, it does not imply that all funds by that respective manager are in trouble or that the fund manager has a problem.
"All investors should be communicating with their adviser, or the adviser should be communicating with their clients, to ensure that they understand where the funds are invested and that they own the funds, not the manager," Mr Smith said.
