Jenny Ruth: 8.5pc return, but still junk

You may think Infratil's infrastructure bonds are a good investment. The latest offering will give you an 8.5 per cent annual return through to the November 15, 2015, maturity date.

And if you don't want to hold them that long, you could always sell them through the stock exchange since they will be listed.

Infratil's previous bond issues augur well. All three issues still trading are selling at lower interest rates, meaning their value has risen beyond the $1 face value.

The bonds maturing in November next year pay 9 per cent annual interest but are trading at 7.45 per cent, those maturing in November 2011 pay 8.5 per cent a year but are trading at 8.1 per cent, and those maturing in September 2013 pay 8.5 per cent but are trading at 8.35 per cent.

Infratil can raise up to $200 million with its latest issue, although its target is $70 million, says executive Tim Brown.

Given the appetite of Kiwi "mums and dads" for debt securities, I wouldn't be surprised if Infratil exceeds that target.

The company has raised a total of $256 million since starting its bond programme in 1999 and has repaid $101.3 million, the first two issues.

But while Infratil is a quality company with good assets and a proven track record, these are still junk bonds. The big beneficiaries aren't the bondholders but Infratil itself and its shareholders.

The bonds are unsecured and unsubordinated, ranking ahead of just Infratil shares if the company were to be wound up. They would rank equally with all other unsecured creditors.

The bondholders don't have any say in how Infratil is run either - that's a shareholder right.

Infratil has the right to issue more bonds without the say-so of the existing bondholders, curbed only by its convenant in the trust deed to limit its total indebtedness, including the bonds and bank debt, to 50 per cent of tangible assets at its half-year and full-year balance dates. The company doesn't include any intangible assets in its balance sheet.

Since Infratil can elect to convert the bonds to shares instead of repaying them, regardless of the bondholders' wishes, that isn't a particularly serious limitation. If bondholders were forced to accept shares, they would get them at 98 per cent of the market price.

Infratil also has the right to buy back or redeem the bonds early. If that happened, bondholders would get the greater of the face value or the market price.

The bondholders do have the comfort of Infratil's record of conservatism: in the year ended last March, its total liabilities, including $154.6 million of bonds, represented only 35.4 per cent of total assets.

The reality is even more conservative than these figures suggest since liabilities include those of its subsidiaries, Wellington International Airport and Glasgow Prestwick Airport, for which Infratil has no direct obligation.

But the company does have bank facilities allowing it to borrow up to $70 million and could probably take on more debt. Net bank debt at September 30 was $20 million, which will be repaid by the present issue of bonds.

While 8.5 per cent might look a juicy interest rate, it pales in comparison with Infratil shareholder returns.

As the investment statement points out, Infratil's shareholders have enjoyed an average after-tax return of more than 20 per cent a year in the 10 1/2 years of the company's existence. The shares have out-performed the New Zealand Exchange benchmark in all but one of those periods.

But the shareholders don't just have to rely on a rising share price since the company has a habit of paying tax-paid dividends. It paid 5c as its first-half dividend this year, a gross payout (the bond interest paid will be gross) of 6.67c, and a total of 12c in the year ended March, or 16c gross.

At Infratil's $3.30 share price, the dividend return for the latest year would be only 4.8 per cent but, if you had bought the shares two years ago when they were trading at $1.75, the dividend return would be 9.1 per cent. And you would also have enjoyed the rising share price.

True, the returns on an investment in the bonds are certain while those on the shares aren't. The company didn't pay a first-half dividend in the year ended March 2003 and could decide not to pay dividends in future periods.

Infratil has a policy of paying dividends only when it has sufficient tax credits to make them fully imputed, and it didn't have enough in 2003 to allow the payment of first-half and final dividends "at material levels".

Higher tax-paid profits from its 35.2 per cent stake in TrustPower - its largest investment, accounting for 53 per cent of total investments - allowed it to resume paying a first-half dividend as well as a final one this year.

About 25 per cent of its assets are abroad - the Glasgow airport and 13 per cent of Australia-based Energy Developments - which won't generate imputation credits and the company is actively investigating other overseas investments.

The company also prides itself on its willingness to take a long-term view, for example its partnership with Waitakere City Council to develop Whenuapai into a commercial airport, which could mean lower returns on some investments.

And because it buys and sells investments, its profits tend to be lumpy. Net profit peaked at $34.2 million in 2000 and dropped to $16.5 million the next year. The latest annual result of $22.5 million was down from the $28.1 million earned in 2003. This year's first-half net result of $29.6 million was more than double the previous first-half's $12.5 million, largely due to the sale of 4.2 million Port of Tauranga shares.

ABN Amro's Matt Henry estimates that Infratil will be able to pay out at least 10c a share each year on a sustainable basis.

Another disadvantage is that, unlike the bonds, the shares tend to trade at a discount to net asset backing. The $3.30 price is a 6.3 per cent discount on its $3.52 net asset backing (as valued by ABN Amro).

And there's always the risk that management won't be able to continue finding high-performing investments.

But a proven record over 10 1/2 years of delivering 20-plus returns still looks a lot better than 8.5 per cent. All in all, investing in Infratil's bonds looks like a mug's game to me.