Cash and fixed interest investments
Lending your money in return for payment of interest
Lending money in return for interest is a form of investing nearly everyone is familiar with. You do it every time you put money into a deposit account with your bank, building society or credit union.
However, the financial world has a host of other products you can invest your money in, with the same common fundamental features. They promise to:
- pay you interest, and
- pay back what you lend them within a set period of time.
You'll earn a higher rate of interest if you lend your money for a longer period of time, or if there is more risk involved in the borrower being able to repay your loan. You have to use a banker's skill in judging if your borrowers can pay you the interest on time and pay back the loan when it's due. Fortunately, with a little digging, you can find the information you need and make some simple safety checks before you invest.
Direct or indirect lending?
There are 2 main ways you can invest your money for interest:
- Direct lending (fixed interest products) – which include putting your money into interest earning deposit accounts with banks, building societies and credit unions and investing in finance company debentures, bank bills, Government and corporate bonds.
- Indirect lending – through managed funds such as cash management trusts, bond trusts, mortgage trusts and other managed funds that may invest in a wide range of loans. Investing indirectly through managed funds helps spread risk across a larger number of borrowers.
There are some basic issues that you should consider before choosing an interest bearing investment product. They apply equally to direct and indirect lending but for simplicity, we will discuss them here using examples from direct lending.
For more information about indirect lending go to our managed funds homepage
Where does lending money fit into your investment plan?
Unless the amount of money you have to invest is relatively small or you are investing for a very short time, all good financial plans will split your money up among a range of investment types, in order to spread risk. Having some of your money invested in interest bearing investments will reduce your risk. Here are some reasons why you might prefer to invest in lower risk interest bearing products. You might want to:
- Park your money for a short time. If you just sold your house and are still looking for another one, you might invest in a term deposit or a cash management account to park the money till you need it.
- Hold money that you cannot afford to lose. For example, money to cover emergencies, or needs you expect to crop up within a couple of years whether it's school fees, an expensive trip or retirement living expenses.
- Save the money for a large expenditure you’re planning in 2-3 years time. For example, a trip overseas, deposit on a car or house
- Reduce risk in your investment portfolio. Companies in which you own shares may cut or suspend dividends, or you may have trouble letting your investment property, so if you depend on your investments for all your income (retirees for example), it might be reassuring to know that you will still get income from interest on bank accounts or government bonds. Superannuation funds and investment managers may use bonds to reduce their risk of losing money from falling share or property markets.
In general, lending money can offer safe but modest returns, so experts tend not to recommend it as a way to build your wealth. After all, you get back only the money you originally lent, so you rely entirely on the interest to:
- preserve the spending power of your money against inflation,
- give you an income, and
- compensate you for the risk you take that the borrower may default, that is not pay you your interest or give you your money back.
Choosing an interest bearing investment product to suit you
Before you start comparing products offered by different financial institutions or companies you must make sure you:
1. Understand the risk involved in the investment
Always remember this fundamental truth when lending money, the higher the return, the higher the risk.
Your fundamental risk is that the borrower may not be able to pay interest when it is due, or may not be able to pay back what they borrowed. If either of these events occurs, the loan is in 'default'.
Some of the most devastating financial losses that Australians have suffered in past years occurred when they chased returns that were 'only' 1.5% or 2% higher than the going rate for that type of loan. Even 1.5% is a highly significant amount in the world of lending.
Here's a couple of quick safety checks. Compare the rate you have been offered with the going rate offered for:
| 1. | the Commonwealth Government would pay for an equivalent loan, for example a 5 or 10 year Commonwealth bond, |
| 2. | you yourself would pay for a home loan. |
These two checks show you what the professional money market and the banks are presently expecting from good quality borrowers, based on their long experience in judging the riskiness of loans. Even fractions of one per cent can send an important message to the market that one loan or borrower is riskier or safer than another.
If you seek higher returns, then find out about the extra risks. They will be there. If you can't work them out, you'll be safer accepting an investment with a lower return.
Levels of risk and return for types of fixed interest products
Find out exactly what product you're looking at. Here's a general summary.
| Fixed interest products currently widely advertised to retail investors |
| What they’re called | Who offers them | Fixed interest risk and return levels |
| Term deposits | Offered by banks, building societies, credit unions and other prudentially regulated institutions. | Lower risk because the institutions are specially regulated by APRA, see deposit accounts.
Lower returns. |
| Cash management trusts | Offered by licensed businesses through a product disclosure statement. | These trusts are not APRA-regulated. Risk and return will depend on what the trust invests in: see the product disclosure statement, particularly to see whether they have a recognised investment grade rating (see our discussion about ratings below). |
| Government bonds | Offered by governments on advertised terms and conditions. | Payment of interest and of capital at maturity are government guaranteed. Australian Government bonds are highly secure, and returns tend to set a benchmark for the market. |
| Debentures and unsecured notes or unsecured deposit notes | Offered by companies through a prospectus. | Not all debentures are the same. Investors rely entirely on the financial strength of the company and the security that is offered.
Higher returns mean higher risks. |
| Mortgage debentures | Offered by companies through a prospectus. By law must be secured by first mortgage over land given to the trustee. Loan to valuation ratio may not exceed 60%. | Not all debentures are the same. Accuracy of land valuation is a key issue.
Higher returns mean higher risks. |
Ratings for borrowers and loans
Another safety check you can make before you invest is to find out the rating given to a loan or borrower by the ratings agencies.
In financial markets, major corporations borrow money from investors on all sorts of different terms and conditions. To help investors judge the riskiness of the borrowers, professional ratings agencies give a credit rating to the corporation and often to the particular loan being raised. This helps them compete for funds. For example, the Commonwealth of Australia holds a AAA rating, indicating our very strong financial position. That means the Australian Government can borrow funds at a lower rate of interest than a country with a lower rating.
'Investment' grade loans and below
An important dividing line lies between loans given an 'investment grade' and those given 'below investment grade'. 'Below investment grade' indicates a much higher level of risk that a loan or borrower may default. Large institutions, superannuation fund trustees and professional investment managers will often refuse to lend to anything that's rated 'below investment grade'.
For that reason low grade loans, sometimes called 'junk bonds' can offer quite high interest rates. While these loans can prove very attractive if all goes to plan, lenders can easily end up losing everything if the company or project fails.
In fact major projects often get financed through a cocktail of:
- high grade, well secured loans,
- middle ranking loans that pay extra interest but offer only 'junior' security, and
- low grade loans that offer little if any security.
If the project fails, the high grade, well secured loans get paid back before the lower grade loans.
2. Know who's borrowing and what security they offer
If you lend money, it's vital to know exactly who is borrowing it. For example, corporations may set up subsidiary companies to borrow. In some cases, the parent company may guarantee the debts of its subsidiary, but not always. Check the loan documents carefully before you invest.
Find out what security is being offered for the loan. If a borrower cannot pay back your money, then if you're a secured lender you may get something back from the sale of whatever secured the loan.
Just about anything can be offered to secure a loan, for example:
- registered first mortgages over owner occupied residential property
- 'charges' (a kind of mortgage) over company assets such as plant, equipment and inventory
- bills of sale over items ranging from cars to paintings.
As the lender, you must judge how much the security is worth if the borrower should default. For example, banks may lend up to 85% (or more) over your home, but far less over vacant land or goods for sale.
Check the security you get offered closely. Many people got burned in solicitors and finance brokers mortgage schemes by not being told exactly what type of land was mortgaged to secure their loans and its real worth. Assume that borrower's valuations may be too optimistic. For example, valuations for property developments can be based on the completed project. If the development fails before completion, the land with a half-finished building could be worth even less than the land before the project started.
After all you may have noticed that bank valuations of people's homes are usually lower than the price the borrowers paid for them. The bank is trying to protect itself, so do the same when you play the banker.
3. Read the prospectus or product disclosure statement
Your financial services provider must give you a product disclosure statement (PDS) when they recommend or offer to sell you:
- managed investments
- superannuation products
- insurance products
- retirement savings accounts
- deposit products
- derivatives.
For shares, debentures and unsecured notes, the seller must give you another type of document, usually a prospectus.
The prospectus or PDS, must give you enough detail to allow you to compare a range of similar financial products and make an informed decision about which ones to invest in.
More information about product disclosure statements
4. Know whether you can get your money back early, should you want to
Sometimes you may need to get your money back early. Before you invest, check if this is possible and if any fees or penalties apply.
If you’ve invested your money in fixed interest products, there's a ready market in many 'second hand loans', called the bond market. Check if your intended investment is traded there, because you may be able to sell the investment to someone else even if the borrower won't let you out of the loan early.
You can make profits and losses on your capital by selling loans on the market. Suppose you bought a 10-year bond, and then you decide you want your money back. You can sell it through a dealer on the bond market.
The price you will get will depend on three things:
- Current interest rates. Suppose you bought a brand new 10-year bond yesterday with an interest rate of 5% per year. If interest rates halved overnight to 2.5% per year, then the income from your bond may now be twice as valuable. If interest rates had doubled to 10%, the income from the bond may now be only half as valuable. So if you sell your bond, the price you get will go up if interest rates have fallen or down if they have risen.
- How 'old' the bond is. If there's ten years' interest payments to come, you'll get more than for the same bond if there's only one year of payments left.
- Fees for selling your bonds.
If you invest in loans and need flexibility, you may decide to invest only in loans that you can trade. Loans you cannot trade may not permit early payouts or may involve heavy fees and penalties.
Bond trading
Trading in bonds for a living is a form of investing, or speculating, that lies outside the scope of these articles. It is largely a professional's game, totally unsuitable for you if you are just getting started.
Some licensed managed funds actively trade their bonds instead of just holding them until they get paid back (or 'mature'). For this reason, if you invest in a managed fund that actively invests in the bond market, you may receive capital profits or losses on top of the interest income the fund ordinarily receives. Check the fund's product disclosure statement.
Occasionally you may run across investment offers from unlicensed businesses for 'high yield bond trading' and 'prime bank instruments'. These are frauds. Report them to ASIC and never get involved.
Find out more
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FIDO Website: Printed 07/26/2008
