Bernard Hickey: Risky business demands stronger returns

The corporate bond rush of the past six months was too good to be true and investors risk making the same mistakes they made during the finance company boom - not being sceptical enough and not demanding enough yield for the risk.

Investors need only look overseas to see bond issuers having to pay much more than the 7-8 per cent being offered here.

Investors have poured over $2.6 billion into corporate bonds since October at interest rates ranging from 6 per cent for an AA-rated issue to 9 per cent for 5- and 7-year unrated bonds.

These bonds are not guaranteed by the Government, whereas money invested in banks, building societies and finance companies is guaranteed until at least October next year.

The iTraxx index for credit default swaps (CDS) for Australian investment-grade bonds (BBB-minus and above) shows the market "spread" to ensure these bonds are around 4.5 basis points above base rates of around 4 per cent, meaning a final rate of 8.5 per cent. International investors are nervous about rising default rates and want a very high premium.

US investment-grade debt is trading at 3 per cent above the safest type of debt. European "junk" or sub-investment grade debt is trading at 11.7 per cent above the safest type of debt.

New Zealanders seem oblivious to the likely deterioration in corporate defaults over the next five or so years. Moody's has forecast that 15 per cent of speculative-grade debt is likely to default in coming months.

So how should New Zealand debt issues be priced? Currently our five-year swaps rate is around 4.06 per cent, up from around 3.7 per cent in the past month. This swaps rate is likely to go well above 5 per cent by the end of the year, I believe, meaning 5-year investment-grade bonds should be offering well above 8.5 per cent.

Of the recent issues, only Tower (8.5 per cent) and Fletcher Building (9 per cent) offered a rate as high or higher than that. Neither carries Standard and Poor's ratings, although Tower has a BBB-minus rating from AM Best. You could argue neither is investment grade and should be offering more than 10 per cent.

Auckland Airport at 7.25 per cent and Wellington Airport at 7.5 per cent simply did not offer enough return for the risk involved. A collapse in tourism would hurt both. Contact Energy's 8 per cent return also underpriced the risk involved, given it had a relatively weak BBB credit rating.

New Zealand corporate bond investors should be demanding at least 9 per cent for five-year investment grade bonds, given inflation and Government bond yields are widely expected to rise sharply in the next five years. Speculative or "junk" bonds should be offering at least 12 per cent.

Another thing for investors to consider is the competition for term deposits between banks. ASB is offering 5 per cent for two years, while ANZ is offering 5.25 per cent for two years. BNZ and Westpac are offering 6 per cent for five years.

* Bernard Hickey is the managing editor of www.interest.co.nz, a website for investors and borrowers wanting free and independent news and information about interest rates, banks, finance companies and the economy.