Commercial Importance of the time-horizon

Press, 31 October 1977, Page 26

Commercial Importance of the time-horizon

By

ADRIAN BROKKING,

commercial editor

“Happy the man who does not have to eat his words of the previous day,” says an old Finnish proverb. Readers have written regularly criticising some of my statements. Some weeks ago a reader was adamant that the savings model did not take sufficient account of inflation. This reader has been invited to supply an alternative model, so this matter will probably be reopened at some future date. But so far I am not eating my words. My latest article, on the effect of changes in interest rates on the value of investments, has come under attack from an Ashburton reader.

This reader’s letter reads: “In the article ‘lnterest rate affects yields’ he (Adrian Brokking) says inter alia that ‘for two propositions to be of equal merit, the second-hand stock would have to sell at half the original price.’ He quotes $lO,OOO worth of new stock

|at 10 per cent would be worth $20,000 of secondary stock at 5 per cent. “While this calculation is true when determining yield on the sharemarket it is not true for the stockmarket. Mr Brokking has misled readers in making this statement. “The percentage yield on stock is calculated on the total income received from the investment during the period the stock has yet to run. This income is both capital gain as well as interest. “To take a simple example, if $lOOO of new stock bought for 10 per cent for three years, $3OO will accrue by way of interest.

“On the secondary market the same amount of stock at 5 per cent for three years, will realise $l5O interest. Therefore there must be a capital gain of $l5O to bring the accrued income to $3OO. Thus the old stock would be bought for $B5O and not $5OO as Mr Brokking would

* have us believe.” r This comment is truejust as it is true that wher > there is an obligation on th ; part of the borrower to re t pay the principal sum bor ■ rowed at an even earlier dat< ; —say within the year—thi ; value of the investment ii largely insulated from a sub i stantial fall. In this case the fall ir price is checked by the know ledge that within a year Slot cash will be repaid for everj $lOO nominal of the stock. To stick to our example if the stock carries a coupor of 5 per cent and the would be investor wants a yield ol 10 per cent, he will be assured of an all-in income ,ol 10 per cent if he buys somewhere between 95 and 96. If he pays 95 he will be able to buy with $lOO about $lO5 worth of stock, $105.26 in fact. On this he will receive an income, at 5 per cent, of $5.26, and at the end of the year he will be repaid the principal of $105.26. In all he therefore receives $110.52 for everv $lOO invested. This example, and the earlier one, once again demonstrates the importance of the “time horizon.”

For if redemption of principal is more than 10 years away — always given the figures used in opr examples — you would indeed have to buy the old stock at 50 for the two propositions to be of equal merit. In last week’s article I did not mention redemption because I was more interested in making the point: that changes in the rate of-interest affect the pricing of all pre-

vious investments. All invest- - ments, not just Government J Stock. 3 In New Zealand Govern- - ment Stock is issued with a - definite maturity date, a date 5 on which the Government will ! repay the loan. > This is not so in all coun- ■ tries. In the United Kingdom most Government Stock is rei deemable at the Government’s option. i The oldest existing Govern- ' ment Stock in the United Kingdom is Consolidated Stock, with a coupon of 21 per cent. Needless to say, the British Government is not going to refund that stock while interest rates are higher than 2| per cent. Soon after the war. interest rates in Britain actually declined for a short period, and the British Government refunded the original 3 per cent Local Loans stock into new 2| per cent Treasury Stock (the “Daltons”), thereby saving the country 0.5 per

cent a year on the stock re funded.

This is not the position now; interest rates in Britain have been consistently higher since that conversion. That is why you can buy in England “War Loan” at £32.25 for £lOO nomimal.