Gaynor: Welcome to an investment secret

By BRIAN GAYNOR

Amid all the gloom and doom of the past 10 days there has been one bright spot on the investment scene: the fixed-interest market.

This market, which offers high-income yields and capital gains, is one of New Zealand's best-kept secrets. As interest rates have fallen over the past few weeks the value of fixed-interest securities has risen and investors have been able to sell their securities on the secondary market at a profit.

Since September 11, two-year Government stock yields have fallen from 5.6 to 5 per cent and five-year stock from 6.24 to 5.94 per cent. These securities are now selling above their original issue price.

It has also been a good period for corporate bonds. The yield on Transpower's 8 per cent bonds, which mature in June 2005, has fallen from 6.49 to 6.1 per cent and the yield on Contact Energy's 2003 bonds, which have a coupon rate of 7.25 per cent, has declined from 6.4 to 5.94 per cent. Both securities are also trading above their original issue price.

Several other fixed-interest securities, including issues by Auckland City Council, UnitedNetworks, Electricorp, Montana and Powerco, have also increased in value as interest rates have fallen.

But in the flight to quality following the United States terrorist attacks several fixed-interest securities have fallen in value.

Brierley Investments (BIL) has been hurt by the anticipated downturn in the UK hotel industry and by Air New Zealand's problems. The yield on BIL's 2007 capital notes, which have a coupon rate of 8 per cent, has risen from 11.6 to 12.35 per cent and the price has fallen from $87.82 to $85.26 per $100.

Investors who believe BIL will stick around for another six years, and meet all its obligations, can obtain a very high return on the group's capital notes.

In the past 10 days the yield on Trans Tasman Properties' 10 per cent capital notes has risen from 11.05 to 11.95 per cent. This is consistent with the view that the United States terrorist attacks will have a negative impact on commercial property markets throughout the world.

With central banks continuing to cut interest rates the outlook for the fixed-interest market remains positive. But there are risks attached to this market as an economic recession will inevitably lead to company failures.

Air New Zealand planned to have a capital notes issue at the end of last year. If this issue had proceeded, holders of these securities would be extremely nervous at present.

Brokers offer a wide range of fixed-interest investments through the Stock Exchange's secondary market. Most of these have been issued by the NZ Government, local authorities, Government-owned corporations or Stock Exchange listed companies. This gives them a relatively higher degree of security compared with many of the high yielding property bonds.

Sky Network Television's unsecured capital note issue is one of the most attractive new offerings available at present. The issue, which will raise $125 million, opened on Monday and is being extensively advertised on television and in the print media.

Proceeds from the capital notes will be used to repay Sky's bank debt, to pay for the expansion of its customer base and to offer new interactive services to subscribers.

The interest rate on the notes will be the greater of: the five-year Government Stock rate plus a margin of 2.75 per cent per year; or 9.3 per cent per year; or such higher rate as Sky and organising broker JBWere may determine and advise to the market before the closing date. (The closing date will be the earlier of October 26 or the date on which the issue is fully subscribed.) Based on the latest Government Stock rates, the coupon rate will be 9.3 per cent.

The capital notes rank ahead of Sky's ordinary shares but are subordinated in right of payment to the claims of Sky's other creditors (except those creditors which are subordinated on a similar basis).

As the notes are unsecured they have a degree of risk and potential investors must consider the long-term viability of Sky Network Television.

Sky is unusual in that it has a strong customer base yet has recorded total losses of $69.3 million in the 24 months to last June. This is because of the high costs and depreciation associated with its rapidly growing customer base.

On the positive side, the company has generated $103.4 million of surplus operating cash over the past two years and if subscription growth slows, group profitability will rise rather than fall.

But Sky is a consumer-oriented company and most investors are in a position to judge for themselves whether the network's programming will continue to attract and maintain subscribers.

Sky has reserved $15 million worth of capital notes for its shareholders. The shareholder entitlement, which closes on October 1, will be snapped up because the capital notes are expected to trade on the secondary market at a premium to the issue price. The notes also offer a high-income yield, whereas Sky does not pay a dividend on its ordinary shares.

One of the most important features of the Sky note issue, and most other capital notes, is the conversion terms.

Sky's capital notes have an initial conversion date of October 15, 2006. Before this date Sky will advise noteholders of the proportion of the capital notes it intends to redeem for cash and, if applicable, the terms and conditions on which noteholders may elect to rollover their notes.

Unless Sky has given notice that it will redeem all capital notes for cash, noteholders can chose to retain some or all of their capital notes for a further period under new terms and conditions and/or convert some or all of their capital notes into Sky ordinary shares at a price equal to 98 per cent of the average sale price of ordinary shares sold on the NZ Stock Exchange.

Sky can decide to override the second option and redeem the capital notes for cash instead of issuing ordinary shares. To date, most companies have taken this course of action and have paid cash instead of issuing ordinary shares.

The option to convert into ordinary shares is confusing for investors who do not wish to hold ordinary shares. The current offer to Brierley Investments note holders is a good example of this.

Brierley Investments' 2001 capital notes mature on October 15 and holders can elect to rollover the capital notes under new terms (under the new terms the notes will pay interest of 9 per cent a year and mature on October 15, 2004) or convert the capital notes into Brierley Investments ordinary shares at a price equal to 98 per cent of the ordinary shares.

Many investors will choose the rollover option because they do not wish to own BIL ordinary shares. But if they make this decision they will immediately face a capital loss because the group's existing 2004 capital notes have a secondary market yield of 12 per cent.

The best option for BIL 2001 noteholders is to choose the ordinary share option and hope that BIL will continue to offer cash instead of shares. The fixed-interest market still has good upside potential but investors would be well advised to place a greater emphasis on security over yield.

* bgaynor@xtra.co.nz