Weak disclosure, high risk

By DAVID VAN SCHAARDENBURG*

Open the business pages of the Weekend Herald print edition and you will see a plethora of advertisements for interest-bearing debt investments.

With global equity markets delivering negative returns in each of the last two years and many listed New Zealand companies displaying inconsistent earnings trends, it should come as no surprise that in recent times investors have increasingly sought the supposedly safe shores of debt investment land.

To seize this opportunity, in the past two years, a record number of 20 New Zealand capital note issues have raised over $2 billion in debt capital. Over the same time frame, mortgage-based managed funds have had net inflows of $1.1 million. Additionally, new finance companies have proliferated.

With so many debt investment opportunities, the logical question the discerning investor will ask is: "It doesn't make sense to invest in all debt investments, so which offerings will give me superior risk-adjusted returns?".

Unfortunately, within a New Zealand context, there appears to be no answer except: "I know the returns for each investment and therefore the return variations between issues. However, using publicly available information, I have no meaningful basis upon which to work out each debt investment's risks of default relative to other debt issues."

As it is not required either by law or demanded by investors, in contrast to banks most finance companies and capital note issuers do not have credit ratings compiled and publicly released to help investors grade the level of risk inherent in each debt investment issue.

Irrespective of the limitations of credit ratings, the lack of externally compiled expert credit risk assessment (such as provided by credit raters S&P or Moody's) leaves the investing public with no credible basis upon which to assess relative risk.

Therefore, an investor is unable to work out whether each debt investment offers the appropriate return relative to other issues.

From the promoters' and investment bankers' perspectives this is great - no cost of credit assessment and the ability to set their cost of debt capital based on non-financial criteria such as marketing.

A combination of limited legal disclosure requirements and financial reporting, plus an absence of expert independent risk assessment, serves to increase risks to investors - often without offsetting additional return opportunity. Such risks tend to be highest at the point of lowest credit quality/highest yield.

How do market conditions in New Zealand compare with market practices in international financial markets?

In the US, by far the most diverse debt market, the overwhelming practice is to get a credit rating at time of initial debt investment issuance which is subsequently updated on a regular basis. For investors, this provides a ready reckoner of the level of return above Government debt appropriate for each debt issue in the market, based on:

* The yields for existing other debt issues of same or similar credit rating.

* The potential for default based on historic rates of financial failure for the same credit grade.

New Zealand's lower level of financial disclosure and limited number of credit ratings leads to interesting comparatives between the current credit spreads - the interest yield above Government bonds - for higher yield NZ debt investments vs US-based debt investments.

It does appear that US-based investors are getting substantially better returns from debt investments at similar levels of credit risk versus their New Zealand-based counterparts. The divergence becomes more pronounced as levels of credit risk rise. We believe the anomaly is substantially created by New Zealand's relatively weaker financial disclosure requirements plus investors not demanding external credit ratings.

So how can this undesirable paradigm change? In relation to higher credit risk debt issuers, such as finance companies and capital note promoters, a combination of increased legal disclosure requirements and the market demanding credit ratings on all debt issues. Based on the US example, these changes provide a route for investors to extract superior returns.

We have often heard professional debt investors complain that the acceptance of unduly low returns by retail investors on higher risk debt investments undermines their ability to demand increased yields or increased disclosure/credit rating from such issuers. Collectivisation and activism by retail investors - via the Shareholders Association, for example - has started to occur in recent times with respect to equity investing. It may also be time for a similar move by debt investors, with the aim to reduce the risk of unexpected debt investment defaults and the consequent loss of investor wealth.

* David van Schaardenburg is executive chairman of investment strategy and funds management research company FundSource.