18 October 2017

How to invest a lazy $900 million

What could possibly go wrong?

In September 2007, the NZ arm of one of the world’s biggest and most secure financial institutions launched a-then record $900 million bond offer to retail investors.

The debt-raising by the Netherlands-headquartered Rabobank – ranked among the top 25 safest banks by the Global Finance magazine – was certainly attractive to the many thousands of ‘mum and dad’ investors in NZ who piled into the bond. 

And those investors would not have been disappointed with the 9.5 per cent income the Rabobank bond returned to them during the first 12 months after issue.

But of course, it couldn’t last.

Many Rabobank bond investors may not have realised that the annual income their investment generated was closely tied to the broader interest rates set by the Reserve Bank.

Unfortunately for those Rabobank bond-holders September 2007 was something of a high-tide mark for official interest rates in NZ and globally. Over the following couple of years central banks – including the Reserve Bank of NZ – drastically slashed interest rates in an attempt to hose down the-then flaming Global Financial Crisis (GFC).

The collective central bank emergency efforts may have prevented the world’s economy from further burn-out, but it also doused the return prospects of so-called ‘safe’ fixed income investments such as the Rabobank NZ bond.

According to a recent paper by the Wellington-based fund manager, Harbour Asset Management, the annual Rabobank bond return fell from 7.5 per cent in its second year after issue to 4.1 per cent over the following 12-month period.

By 2016 Rabobank bond investors were making do with an annual return of just 2.9 per cent. 

“Put simply, investors had been directly exposed to interest rate risk, and felt the brunt of global interest rates falling to levels that were unanticipated before the GFC,” the Harbour analysis says.

While the rapid decline in the annual income provided by the Rabobank bond was shocking enough, many investors probably compounded their losses by bailing out at just the wrong moment, the Harbour paper says.

Rabobank offered the bond to NZ investors initially over a 10-year period. On closer reading of the finer points of the deal, however, investors would’ve noticed that Rabobank was not obliged to pay back the principal after 10 years – technically, the bank could’ve held on to the capital forever.

But there was an early exit for Rabobank bond-holders via the ‘secondary market’ where other investors could buy the debt – at a discount.

Over 2007-2009 the secondary market price of the Rabobank bond fell from the issue level of $1 to as low as 75 cents: a bottom-of-the-barrel figure that the Harbour paper says more than a few investors accepted.

“Some sellers may have needed the proceeds for personal reasons; but many others probably sold as nerves won over after observing others selling, and weighed out the chances of further losses,” the study says.

Harbour says the Rabobank bond experience provides three valuable lessons for NZ fixed income investors.

“The first lesson is to know your investment,” the study says.

Although fixed income/bonds may sound more straightforward [than, for example, shares] in practice they can be far more complex.

Secondly, the fact many investors sold out at the bottom highlighted the strong influence of human behavioural flaws when it comes to financial matters.

“One of these is the aversion we have to experiencing losses; another is following herd behaviour over making a cold, hard analysis of the facts,” the study says. 

Finally, the Harbour paper says the plunge in Rabobank bond returns in a short space of time reinforced why fixed income investors should not rely on a single investment – no matter how ‘safe’ it appears – to meet their needs.

For instance, Harbour, which manages some of the fixed income assets for the Lifetime Income Fund, says professional NZ investment managers typically include between 80-100 bonds (representing up to 50 different issuers) in their portfolios. 

On October 8 this year, Rabobank officially put NZ bond investors out of their misery by paying back their principal that had been locked away for 10 years: seeing $900 million released into the hands of some, possibly, better-educated ‘mums and dads’.

How those ex-Rabobank bond-holders deploy their newly-returned capital will be the true test of how much they have learned. The increasing number of ‘high yield’ products currently popping up in NZ could tempt retail investors to repeat past mistakes.

On the upside, though, NZ investors have a wider choice today of professionally-managed fixed income options as well as innovative guaranteed income choices like the Lifetime Income Fund.

Hopefully this will help things all go right.

Article written by David Chaplin, Lifetime Retirement Income.

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