Brent Sheather: Clouds over finance firms

At around 4 per cent American 10-year Government bonds don't offer New Zealand investors much in the way of interest. But for Mum and Dad pondering the local investment market they might be relevant for what their low level implies about the future.

While homeowners look at low interest rates and rejoice, economists see only dark clouds. Some of these cheerful fellows say the most likely explanation for the near-record lows of US and European long-term Government bonds is that the market is expecting a big slowdown in economic activity.

Others worry that if American consumers suddenly realise how much money they owe and decide to stop spending this could pose a problem for the world economy.

Thus perhaps the real significance of 4 per cent US bond yields to Mum and Dad in New Zealand is that a mild, or maybe even a not so mild, deflationary period may be looming for the US and, by inference, New Zealand.

A slowdown probably won't pose much of a problem for our major banks and companies but it could cause major pain for the clients of finance companies who are borrowing at high double-digit interest rates.

When you have to borrow from finance companies it is unlikely that you have a reliable cashflow positive business. If you did you would probably be borrowing at a lower cost through a bank.

So, it's on the cards that the client borrowing from XYZ Finance is developing some asset, usually a property, which he or she hopes to flick on at a higher price as soon as possible to pay back that loan.

Remember too that funding costs through your favourite finance company only start with the 8-9 per cent offered to Mum and Dad. To this must be added the 1-2 per cent commission typically payable to a financial planner plus the operating costs of the finance company plus a margin for profit. All up costs to Mr Property Developer are likely to be easily in the 11-12 per cent range.

To put that number into perspective, most major listed companies in NZ today would love to find projects which could produce a 12 per cent return as their cost of capital is only around 8-9 per cent.

Often the higher your cost of capital, the greater the significance of a slowdown on your business. With no high inflation down the road to bail out poor investment decisions when the music stops, things could get rather nasty for the entrepreneurs that use finance companies as a prime source of their funding.

New Zealand investors - "mums and dads" trying to squeeze the maximum out of their savings - now apparently have record sums invested in finance company debentures. Are they inadvertently financing the clients the mainstream banks won't?

With levels of debt much higher locally and overseas, the implications of a tougher economic environment may now be significantly different from even a few years back.

It's common practice to think of interest rates as either rising or falling but when the market thinks tough times are coming interest rate markets sometimes do both at the same time - they bifurcate.

All this means is that some interest rates rise and some decline, depending on how reliable the borrowing entity is perceived to be. In a more severe economic climate the interest-rates on risk-free debt like Government stock will fall (and the value of the bonds rise) whereas more risky borrowers, like your average property developer, have to pay more because the probability of their default has increased.

So higher-risk bonds have little value in diversifying a portfolio of equities. At the first sign of trouble they change their spots and act like shares themselves.

Back in the 1930s when the stockmarket plunged and banks went bust, 3 per cent US Government bond prices surged, whereas the prices of risky bonds plummeted.

US long-term bond rates have been trending downward steadily.

One further complicating factor associated with finance company debt is the lack of a liquid secondary market: in other words it is easier to get into than out of.

The secondary market in finance company debentures, whereby people who own the debentures sell out early, is limited.

The significance of this relates to pricing: when the Government issues debt it is priced with reference to the secondary market.

With little or no secondary market in finance company debt, who is to say what the right interest rate is? There is very little institutional investment, meaning that risk may be mispriced.

"Mum and dad" dabbling in the local finance company debenture market should thus keep a close eye on US 10-year bond yields and, if they make another decisive move downwards, fasten their safety belts as things back home could get rather bumpy.

* Brent Sheather is a Whakatane-based financial adviser.