Yielding to temptation

By PHILIP MACALISTER

Shares might be out of favour with investors, but fixed interest offerings, such as capital notes, are in fashion in a big way.

It seems that no matter which way investors turn there is another company offering capital notes which promise a great return on their money.

Clearly investors love this stuff - which comes with returns of up to 10.5 per cent - as more than $1.2 billion has been invested in these offerings in the past six months.

One reason for the surge in capital note issues is that they are a cheap way for companies to raise money.

There is also a lot of money sloshing around in the investment market looking for a home.

One broker says this is because some of the older fixed interest offerings, such as those from NGC and Fletchers, have been repaid.

Fergus McDonald, the head of bonds and currency at Guardian Trust Funds Management, says capital note offers are particularly appealing to "mum and dad" investors as the rates they offer are substantially higher than the 5 per cent or so being paid on term deposits.

However institutional investors generally don't buy the notes, he says, because the quality is too low.

Capital notes have a place in a diversified portfolio, but they can be used in different ways.

Jordi Garcia, who was named Financial Planner of the Year on Thursday night, says capital notes are something he tends to use with older clients who want to lock in a set income stream until maturity.

With younger clients, who are seeking capital growth as well as income, he tends to use managed funds which invest in fixed interest.

The reasoning here is that a manager holds a broader range of investments and also tries to bolster returns by looking for capital gains as well as income.

Mr Garcia says one of the problems with capital notes in New Zealand is that the market for them is "narrow, illiquid and shallow".

This can present problems for investors who want to sell up before the notes reach maturity.

Generally, he says, overseas institutional investors are not that interested in buying them because they are regarded as "low grade" investments.

Capital notes are often graded by the international ratings agencies, based on the credit rating of the company offering the notes. A high grade is AAA or better.

However most of the offers in New Zealand are either lower than this or are not graded at all, and that means they fall into the "junk bond" category.

While capital notes look appealing, and are often promoted by well-known companies, there are risks.

Ratings agency Standard & Poor's recently warned that investments such as capital notes carry "materially higher risks to investors" compared with more highly ranked fixed interest investments - though they are less risky than shares.

The risks have been highlighted in recent years by the failures of two well-known companies - Skellerup and meat processor Fortex.

ABN Amro Craigs research manager Cameron Watson warns people to be careful with capital notes issues and carefully scrutinise the security offered and the quality of the company.

He says the most important thing with fixed interest offerings is security of capital. "Return on capital is secondary."

"Capital notes should be a small part of an overall fixed interest allocation," he says.

The investment world refers to things such as capital notes as "debt" offerings - because the company offering the investment is indebted to the investor - as opposed to "equity" investments such as shares - which effectively give the investor an ownership stake in the business.

Such debt offerings have had a high profile lately because of their number and size. The Stock Exchange is also keen to raise the profile of "subordinated" debt issues - so-called because they rank behind a company's other debts - to encourage people to use them as an alternative to bank deposits.

The exchange is planning to change its rules and allow capital notes and bond issues to be more easily traded.

The changes will encourage brokers to report sales, settle sooner and provide more transparent information to investors.

* Philip Macalister is the editor of online money management magazine Good Returns, which provides news and information on managed funds, financial planning, mortgages, insurance and superannuation.

E-mail philip@goodreturns.co.nz