Brent Sheather: Finance companies not the only losers

The personal finance section of the Herald frequently documents the horror stories of retail investors losing their money by investing in finance company debentures.

However, the finance companies did not have a monopoly in the market for toxic fixed-interest securities.

A close look at the performance of the NZ Stock Exchange's NZDX market for listed debt securities suggests it was relatively easy to do very badly in this sub-sector of the fixed interest market as well.

In fact, if we look at the 108 individual corporate bonds listed on the NZDX (excluding NZ Government Bonds and Telecom bonds) in March 2010, some 51 issues - or 47 per cent - were trading below the price at which they were originally issued and this is despite a major bounce in overseas and local corporate bond markets in 2009.

A large number of investors in the NZDX-listed individual bonds have seen their savings almost wiped out with seven securities trading at virtually zero.

These seven securities, Dominion Finance Holdings Limited, Fortress Notes, Rated Mortgage Trust, Strategic Finance Ltd Preference Shares, Irongate Property and Credit Sails, originally raised $249 million in capital and this amount appears to be almost completely written off.

The table lists the 20 worst performers in terms of the difference between the last sale price on March 31, 2010, and the original issue price.

While the list is dominated by the most risky tranches of finance company debt, there are many instances where the debt securities of relatively respectable industrial companies have fallen dramatically from their issue price and whose original investors have incurred large losses.

For example, in November 2006 Infratil issued at $1 some 239.7 million perpetual infrastructure bonds priced at a 1.5 per cent margin over the one-year wholesale bank rate.

Today the combination of a more risk-averse environment, a low one-year interbank rate (3.4 per cent) and Infratil's low interest cover has meant these bonds traded as low as 60c in the dollar, giving shareholders a loss of 40 per cent in capital terms and excluding interest.

In the same period Infratil's share price fell by 30 per cent.

There are other horror stories. Some 1781 individual shareholders are listed as holding Rural Portfolio Capital redeemable preference shares which were issued by Craig Norgate and Baird McConnon's holding company to finance their ill-fated investment in Pyne Gould Wrightson.

Sixty million of these redeemable preference shares were issued at a price of $1 and a yield of 10.14 per cent. Shareholders were paid out 50c per share on May 31, half of what investors paid in the IPO.

But it is not quite all doom and gloom on the NZDX. While many issues have turned to junk, a number of bond issues have turned out quite well for investors, particularly those which were made by A-rated entities at the depths of the credit crisis.

At that time issuers had to offer higher interest rates to attract investors due to a general aversion to risk. Some of the better performers include the likes of Auckland Airport 2016 bonds, which were issued at $1 and are currently priced at $1.08. Similarly Auckland City Council bonds maturing in 2014 are trading slightly above par at $1.03.

One feature of the better performing bonds is that they were often hard to get and frequently if you asked for $20,000 worth you were allocated just $5000.

So the NZDX market is a bit like the IPO market generally in that as a general rule investors shouldn't take up any issues they get offered stock in.

Looking at the NZDX debt market overall there seem some features common to the worst performers:

* Many are perpetual bonds, which means they have no set date where investors will receive their money back. Investment theory says long-dated bonds are more risky than short-dated bonds because interest rates can change and the further away the date you get your money back the more chance there is the company might go bust. The general underpricing of risk post-2003 has had a greater effect the longer dated the bond.

* Most of the worst performers seem to have offered the highest initial yields.

* High levels of brokerage also seem to be a common feature with poor-performing bonds. South Canterbury perpetuals paid an initial fee of 1.75 per cent, Babcock & Brown subordinated notes had all-up fees of 2 per cent and the Rural Portfolio Capital issue had an all-up fee of 2.1 per cent. In contrast, Auckland City Council bonds paid 0.75 per cent and Auckland Airport paid 1.0 per cent. Many higher-quality bond issues pay no initial commissions at all.

* Complicated names seem to be another red flag. The Babcock & Brown instrument was described as "unsecured, subordinated, cumulative, re-settable notes". Others were known as redeemable preference shares and such like. Most had no credit rating.

Judging by letters to Mary Holm, a lot of people appear to have had bad experiences with perpetual bonds issued by high-quality companies. Infratil, Origin and Fonterra have issued perpetual bonds.

As at March 31, 2010 these bonds were trading at 64c, 73c and 84.5c, respectively, having being issued at $1.

ASB also has two classes of widely held perpetual preference shares but they are listed on the NZX itself.

In some cases advisers appear to have put far too much of clients' money into these products and it would be interesting to know if this was done at the time that the bonds were floated (to get higher rates of commission) or bought on the secondary market.

But there is nothing intrinsically wrong with perpetual bonds provided they are priced correctly, issued by A-rated companies, not overly represented in fixed-interest portfolios and the rest of the portfolio is made up of longer-dated, low-risk bonds.

Many individuals' portfolios would be showing large losses on quality perpetuals but we need to look at their performance in the context of debt and equity markets which were, in hindsight, significantly mispriced in 2005 to 2007, and to remember the high rates of interest holders have enjoyed thus far.

For example, an individual who bought the ASB No 2 Capital Perpetual Preference Shares at $1 when they first listed on December 23, 2004 has had three years of interest rates above 8 per cent and his/her total return as at today, if he/she bought at $1 and sold at 75c, is 2.8 per cent a year versus 6.3 per cent a year in the same period for six-month term deposit rates.

Not good, but not a disaster, either, as long as they were part of a suitably diversified bond portfolio.

* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.

Disclosure: Brent Sheather may have an interest in some of the securities mentioned.