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August 04 newsletter

We decided to update our information on debentures, because of a recurring comment in the marketplace which goes something like this: "it's not a matter of if a finance company goes belly up, it's just a matter of when".

We thought it might be a good opportunity to cut through the marketing hype to point out a few things that you should consider when assessing your debenture investment.

The first step is to understand what these finance companies are all about. Essentially, they borrow funds from you, the investor, and then lend those funds on to borrowers. They make their money by charging a higher interest rate to the borrowers than they pay to you. They stay in business by ensuring that their borrowers can repay the loans, so that, in turn, they can repay the sum of money you invested.

There are about 30 finance companies belonging to the Financial Services Federation, and even more that don't. You can expect an enormous variety in what they do, how big they are and, ultimately, how able they are to protect your capital and pay the interest they promise.

We recommend that investors supplement the information provided by their adviser with a little of their own research.

The two key documents to find, read and understand, are the investment statement and the prospectus.

Some key things to consider include:

• The size of the company. In this case, bigger really is probably better. For example, a bigger company is more likely to have specialists in assessing the quality of the customers they're lending money to. Bigger companies are also more able to diversify their risk across a greater number of customers.
• Who they lend money to. Different companies lend within different industries. the Shape of Money suggests that finance companies which lend to property developers are a much more risky proposition than finance companies which, for instance, lend to established trucking companies.
• Understand what the security really means. For example, if you are investing in unsecured notes, there is no security over the company's assets. Security can range from charges against either specific assets or general assets of the company. Other options include insurance arrangements which are designed to offer protection, in the event that the loans are not repaid to the finance company.
• What else is in the fine print? Some investments will give the finance company the option to "call" the investment. This means that they can repay your investment before it is due to mature. This could happen when interest rates fall, meaning that you suddenly lose the nice income stream you had been enjoying.

What does the Shape of Money recommend?

• Spread your investment across more than one finance company.
• If your investment timeframe is greater than three years, we suggest considering a managed fund that specialises in fixed interest investments. Yes, you do pay a management fee, but you also diversify your risk and get the experts to make the decisions for you.
• We believe it is better to forgo a few percent of interest to protect 100 percent of your capital.

In summary, if you decide to invest directly, we recommend that you read the investment statement and the prospectus and, at the very least, carefully consider the above points.