Newsletter May 2009

May 1, 2009

Education

I have just spent a most enjoyable week with my family in Dunedin and Christchurch where my two eldest children are at university. On the recommendation of a family friend we booked at a restaurant called “A Cow Called Berta” in Dunedin. To me the name of the restaurant indicated a steak and chips type meal, however it was far more upmarket with $40 mains. Earlier in the day we had been discussing the meaning of “equity” with our eldest son who is studying commerce at Otago University. My youngest did the maths through the course of the meal and expressed his concern on what effect our dinner was having on the family’s equity! The discussion reminded me of a number of clients who have asked me to explain certain aspects of investments in the monthly newsletter. Some people are reluctant to ask questions for fear of appearing ignorant – Eleanor Roosevelt once said “there are no stupid questions; the only stupid question is the question not asked.” I receive a number of questions about the bond market and how bonds behave in the secondary market, so I thought that would be a good place to start.

Bonds

There are a vast number of debt securities on the market, many with differing characteristics. For the purpose of this exercise we will look at plain “vanilla” bonds (those with a set term, paying a fixed rate of interest, with repayment at maturity). The most important point to remember when looking at prices of bonds on the secondary market is the inverse relationship between price and yield. All other things remaining equal, as yields (the interest rate a buyer or seller demands) increase, bond prices will fall, and vice versa. Also, the coupon payment (initial rate of interest paid) doesn’t change throughout the life of the bond.

Example: Fonterra’s six-year bond issued in March paying a coupon of 7.75%.
Currently there are buyers in the secondary market prepared to buy this bond at a yield of 7.35%. How does the new owner of the bond yield 7.35% until maturity if the bond keeps paying its same coupon of 7.75%? The answer is that the new buyer must pay more than the face value for the bond (remember the inverse relationship between price and yield). If I want 10,000 Fonterra bonds, at a yield of 7.35% I would have to pay $10,190. At maturity I would be repaid $10,000.
Example: GPG’s capital note maturing in November, 2012, paying a coupon of 8.30%.
Recent trades in this bond have been at yields of 11.75%. If I wanted 10,000 GPG capital notes I would only have to pay $9,010. I would continue to receive interest payments of 8.30% on $10,000, and at maturity I would be paid back the full $10,000.

The other important thing with bonds is their time until maturity. Yields generally tend to match the coupon the closer the bond is to maturity (unless the company has a chance of defaulting). If you owned a bond that was due to mature in one month, you are highly unlikely to sell it for any less than its par value.

Perpetual Reset Securities

Over the past couple of years there have been a number of perpetual debt securities issued, all with differing features. Examples include Rabobank, Infratil, Quayside Holdings, Origin Energy, ANZ, and BNZ. The one common feature of these securities is that in order to get your money out before the company decides to make repayment they must be sold on the secondary market. As an adviser obviously I want to offer products to clients that meet the needs of diversification, liquidity, and a fair return for the risk involved. Liquidity is not a problem with any of these securities as they are all listed on the secondary market of the NZ Stock Exchange; all have good depth (plenty of buyers and sellers), and can be sold instantly. Liquidity is necessary of course, but is of limited use if the security you want to sell is trading at half the price you paid for it. We are seeing some large discounts in the prices of some of these perpetual securities and I thought it might be worthwhile trying to explain why this is.

The first point to bear in mind is there has been a flight to quality over the last year due to the global financial crisis. As a result there are fewer buyers in the market for lower-rated securities. If you were looking to sell your Infratil perpetual bonds for example you would have to accept a heavy discount ($60 per hundred). These discounts were very large immediately following the global meltdown, however have been reducing recently as confidence returns to the markets. The other factor affecting these securities is their reset characteristics. Most have their interest rate reset after one, three or five years. The interest rate paid is based on a benchmark rate plus a margin, and it is the “margin” that is leading to some of the discounted prices we are seeing.

Rabobank issued their first perpetual security in 2007 and we promoted it as offering a very good return for its risk. It paid 9.48% for the first year, and then had annual resets at 0.76% (the margin) over the one-year swap rate. At the time I thought that whatever the movement in interest rates this instrument would pay a return that remained relative to the interest rates of the day. However, with the global financial crisis we are seeing companies raising money being forced to offer higher margins over benchmark interest rates to gain any support. We are seeing it now with Rabobank’s latest offering at 3.75% over the five-year swap rate. Rabobank’s 2007 perpetual security is currently trading at $80 per hundred. Origin Energy is a similar security also trading at a heavy discount ($63 per hundred) – its rate is reset each year at 1.50% over the one-year swap rate.

The perpetuals are not all doom and gloom however. The ANZ and BNZ securities have reset margins of 2.00% and 2.20% respectively over the five-year swap rate, and have traded as high as $109 per hundred in the secondary market. They are currently trading between $100 and $102. Quayside Holding’s perpetual is paying 10.00% and will have its rate reset in March 2011 at 1.70% over the three-year swap rate. It is currently trading in the secondary market at $102 per hundred. I think the lesson we need to take from the variation in prices of these securities is that we need to spread our money, not only across different companies, but across different types of security. If funds are needed, for whatever reason, it is nice to have a range of securities to choose from to sell in order to raise the funds. We also need to be mindful of not allocating too much money to any single security. The large discounts on the likes of Infratil, Rabobank and Origin need not cause concern provided you are not forced to sell them. They will eventually be repaid and are currently paying interest of 6.95% (Infratil), 7.449% (Rabobank), and 8.04% (Origin).

Warrants

Next month I will explain the features of warrants. Some of you will have Infratil or Barramundi warrants and it is important you are aware of your choices leading up to their expiry dates. Infratil has two series of warrants; the first of which expire on 10th July this year, and Barramundi warrants expire on 26th October. Those of you with the July Infratil warrants should be keeping a close eye on prices leading up to the expiry date. If you want to discuss this further please phone the office at any time.

Portfolio Reviews

My main source of communication with clients is through this newsletter. I rely on you to contact me if I can help in any way. A number of you have taken the opportunity to have your investments reviewed, and the offer still stands. If you would like me to look at your investments and offer an unbiased view of risk, diversification, and liquidity, please phone the office and make an appointment. I don’t charge anything for this service and it is a good opportunity for me to get to know clients better. I am happy to come to you if necessary (I like scones and pikelets).

Rabobank

Rabobank Capital Securities Limited is making an offer of up to $200 million of PIE Capital Securities to the public, with the ability to accept unlimited oversubscriptions. The PIE Capital Securities are perpetual preference shares paying quarterly dividends at a fixed rate until 18 June 2014. The interest rate paid will be based on the five-year swap rate, plus a margin (3.75%), and will be no lower than 8.00%. The rate will be set on May 25th. On 18 June 2014 the dividend rate will be reset for a further 5 years until 18 June 2019 at the benchmark five year swap rate plus the issue margin. Thereafter the gross dividend rate will be reset quarterly at the 3-month bank bill rate plus the issue margin. As Rabo Capital Securities Limited will be a Portfolio Investment Entity (“PIE”), investors will have their tax on dividends capped at 30%. The resulting tax benefits may be appealing for investors on 33% and 38% tax rates. The minimum investment will be $5,000, and will carry a Standard & Poors credit rating of AA-.

If the rate was set today it would be 8.53% (five-year swap rate of 4.78% plus the margin of 3.75%). I expect this issue to trade in the secondary market at higher yields than its predecessor due to the better margin on offer.

PLEASE CONTACT OUR OFFICE AS SOON AS POSSIBLE IF THIS OFFER IS OF INTEREST TO YOU (CLOSES MAY 22nd)

Vector

Vector have indicated they may issue a five-year bond, with a rate expected to be around 7.50%. I think they will need to pay closer to 8.00% to gain support as their 2012 bond with a coupon of 8.00% is trading in the secondary market at close to par value.

South Canterbury Finance

SCF are offering 5.50% for 12 months, so falls within the Government Guarantee.

Fletcher Building


Fletcher Building shareholders have been offered the opportunity to take up new shares in the company at no more than $5.35 per share. The issue of new shares will have a dilutionary effect on the share price; however at their current price of $6.30 I would recommend investors take the opportunity to increase their holding.

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