Most finance company debentures 'junk bonds'

Most New Zealand finance company debenture stock would be deemed "junk bonds" if rated by the major international ratings agencies and investors were not being rewarded for the risk of failures within the sector, fund manager Arcus said yesterday.

Chief investment officer Mark Brighouse said that, if New Zealand's more than 100 finance companies were rated by an agency such as Standard & Poor's, "they would predominantly be in the speculative category (BB or less), which is the equivalent of junk-bond status".

S&P's Australasian research suggested the risk of default among companies with a BB rating was relatively high - about 8.4 per cent over five years for BB-rated firms, about 21 per cent for B-rated ones and about 58 per cent for a CCC-rated company.

Furthermore, Brighouse said default rates were also cyclical.

"When the economy is doing well, they will tend to be below this average, but will escalate to levels that exceed this average as conditions toughen.

"The default rates for non-investment grade companies are a lot higher than mum and dad investors believe. It's not surprising, as the environment gets tougher, we're seeing a number encounter difficulties."

Like other commentators, Brig-house didn't believe investors in many unrated finance company debentures were being adequately compensated for their risk.

He said credit rating agency Moody's had indicated investors in speculative grade companies should receive an interest rate premium 4-5 per cent above the rate for a government bond of the same term.

"This means that investors locking in for one year should expect to receive around 11 to 12 per cent to compensate them for the extra risk involved, which is clearly not the case."

AMP senior portfolio manager Peter Scobie said Arcus's analysis was sound. While the finance company sector was like any other - with good and bad operators - "the conclusion is it's a relatively high-risk sector and investors must ask are they getting enough reward for being in there".

Meanwhile, Brighouse was not surprised by the recent failures of National Finance 2000 and Provincial Finance. "There's more to come, that's what we believe," he said.

He said the economic downturn was likely to last much longer than most forecasters anticipated because of high interest rates and the Reserve Bank's latest signal that they would stay higher for longer.

That would increase pressure on the sector, which accounting firm KPMG earlier this year estimated had been growing at more than 20 per cent per annum for the past few years.

Household's debt servicing costs had escalated over the past few years because of rising rates and high debt.

If debt servicing became a problem for consumers, they might avoid defaulting on mortgages for as long as possible, but might not have the same attitude towards consumer loans.

A bit of a punt

* Investment manager Arcus says most finance company debentures are "speculative" grade investments at best.

* The risk of defaults among those companies is growing as the economy slows.

* Investors in those companies are not receiving adequate reward for their risk.