Fixed interest investments have traditionally been an attractive option for investors who are looking for a steady income stream. There are many types to choose, each with varying risks and benefits, so you need to be careful in choosing which is right for you.
The summary below may help you compare the merits of various fixed interest options and we also take a look at a “new kid on the block” that is catching the eye of many investors looking for healthier returns.
Government bonds have long been a mainstay for fixed interest investors, thanks to the attraction of their high security. A government bond is effectively a loan you are making to the government with an agreed interest rate and fixed term. The fact that the government guarantees the return of your principal at maturity makes them safe and reliable, but the interest rates are generally quite modest. Government bonds usually need to be purchased through your broker.
Peer-to-peer lending is a relatively new concept in Australia and holds appeal to investors who are looking for new fixed interest opportunities. The big attraction in comparison to the other alternatives described here is that they offer investors attractive returns by providing them direct access to the previously hard-to-access asset classes of consumer and business credit.
Peer-to-peer lenders match people who have money to invest directly with people who are looking for a loan. This is done using an online platform, which effectively bypasses the need for a traditional financial institution.
Investors get the potential to achieve higher returns while being able to control the level of risk they take on. They can specify parameters on the use of the funds they invest, such as nominating the interest rate, loan period and on some platforms the credit criteria of the loans to reflect their risk appetite.
Apps and online services are bypassing the need for a financial institution
By opening up the market and connecting lenders and borrowers more directly, there is no need to rely on a bank to set the borrowing terms. The transparency, efficiency and control inherent in the concept is driving the popularity of peer-to-peer as an option for fixed interest investors and the fact that platforms open to retail investors are well regulated and must conform to ASIC rules is adding to their acceptance.
Peer-to-peer lending is already well entrenched in the UK and USA and is now entering the mainstream in Australia. One of the pioneers of the concept in the Australian market is RateSetter, a platform that already has more than 6000 investors with over $120 million worth of loans placed and a 100% record on capital and interest payments being made back to investors.
Of course there are still risks involved, but P2P lending platforms place a strong emphasis on control and transparency, helping investors choose the platform and assets that match the risk level they are comfortable with, rather than relying on the whims of a monolithic institution. Some, like RateSetter also provide a Provision Fund which can help protect investors against borrower late payments or defaults. It could be a clever option for those investors looking for a new way to earn competitive fixed interest rates.
Corporate bonds bear some similarity with government bonds in that they involve lending money (in this case to a company) at an agreed interest over a set term, but there are important differences. Bonds can vary greatly in the amount of capital security they offer.
Generally speaking, corporate bonds are less risky than buying shares in a company, but their ability to pay interest and to pay back your capital at maturity can be compromised if the company goes out of business. Bondholders take a higher priority than shareholders if this eventuates, but the risk of capital loss still exists.
Corporate bonds can also be traded prior to maturity on a market such as the Australian Securities Exchange. The market value of a bond on the market may differ up or down from its face value, based on current economic conditions.
Take for example if you were selling a 10 year bond that was paying 5% p.a. interest. If market interest rates had slumped to, say, 2.5%, then the interest income from your bond would be very attractive to buyers and the bond could be sold for a higher price than its face value. Conversely, if market rates had jumped above 5%, then the value of the bond could go down.
Mortgage schemes are a type of managed fund that lends to borrowers to buy property or to undertake property development projects. On the surface these may seem safe and have attractive interest rates, but there are potentially higher risks. Mortgage schemes are often used to raise capital by developers who may not be able to secure loans from banks, due to the higher risks of borrowers defaulting or a property development project going bust.
The term ‘hybrid security’ is a catch-all name that covers a range of investments with odd sounding names, such as ‘capital notes’, ‘convertible preference shares’ and ‘subordinated notes’. These can be highly complex investments that are issued by institutions like banks, but this doesn’t mean that they offer the level of security that you would normally associate with bank investments, (such as term deposits).
Rates can be attractive but in certain circumstances your investment could be converted to shares in the bank and leave you with less capital than you initially invested.