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Are Inflation-Proof Bonds Suitable For Mum And Dad Investors?

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Contributor:
Mary Holm
Mary Holm

Question:

As a general principle I do not think that the government's inflation-proof bonds are suitable for the average mum and dad investor. There are several reasons:

· You have to buy them on the market and the brokers charge too much for mum and dads - the only return that counts is the net of tax and net of costs return.

· While you receive inflation growth, it is taxable. Therefore if inflation takes off you do not get a net real return after tax. And if you went to sell them before maturity the market would price this in. Most people are better to take the inflation risk, particularly because of tax.

· There are times when the market misprices these securities, as the big firms do not follow them, so you might get a bargain. But these instances are few and far between.

On government bonds in general, you should only buy them in certain circumstances:

· Liquidity is important to you, and government bonds are yielding above bank term deposits and above their long term expected average yield, or

· You think that yields on government bonds will go lower, so you can sell them at a gain before maturity, or

· Security is the only important criterion for you.

Few mum and dads should buy government bonds, as in reality the investment grade corporate bonds have more than adequate security and a higher yield, and liquidity can be managed by duration diversification.

Answer:

Mary Holm: Government bonds are versatile creatures. They can be used in quite sophisticated ways by savvy people, but they can also be used simply by people who know little about finance. It would be a pity to scare off that second group from buying any government bonds.

I take your point that the inflation-proof bonds are not generally suitable for them. Nor will they be able to forecast long-term yields on ordinary government bonds, as mentioned in your second list.

Nonetheless, I suspect that in the current environment no small number of unsophisticated investors might want to buy government bonds for your third reason. Security matters a lot.

True, investment grade corporate bonds (rated BBB or higher) are generally regarded as pretty safe. Investors lose their money only if the company goes belly up, and highly graded bonds are issued by solid companies.

And as you say, these bonds have higher yields than government bonds. But that simply reflects that they are somewhat riskier. If nervous investors want the top-of-the-line security of government bonds, I'm not going to get in their way.

For the benefit of others: Our correspondent refers to liquidity - the fact that government bonds may be easier to sell quickly than corporate bonds.

But as he says, you can diversify the duration of your corporate bonds. That means buying several bonds so that you have one maturing, say, every six months or every year. Then, if you need the money, some will come free shortly, so you may not have to sell any bonds before maturity.

 

Mary Holm is the author of bestselling books on KiwiSaver and personal finance. She is also a highly praised seminar presenter. Her written advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following that advice.   

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