Looking for the perfect investment
In the first part of a two-part article AXA gives its views on issues investors should consider when looking at fixed interest investments.
Thursday, January 5th 2006, 10:45PM
It isn’t hard to find the perfect investment. Just open any newspaper and check out the fixed interest offers in the market these days. Offers of first-ranking debentures paying 8%, 9% or 10% per annum, or better, are commonplace.
And this is at a time when the banks term deposits are paying around 6.5% for one year. Meanwhile most managed funds aren’t able to say what they are paying, as returns will be subject to market conditions.
Is it really that easy? A guaranteed higher return is certainly attractive, and there are some very respected names making the offers. A fixed return that beats the banks, with no fees and no risk. Perfect!
Is it really that good? In AXA’s view, we suggest that an investor needs to look deeper than this. Potential investors need to remember some fundamental principles of investing – diversity, and security. Some debentures are good quality – relatively safe, and a good investment. But nothing is really risk-free, and investments don’t always deliver. Like any significant purchase, ‘kick the tyres’ a little before buying, and you might be very surprised at what you find.
How do finance and investment company debentures and bonds work?
Let’s say you have a client with money to invest. A finance company debenture has taken their eye. If they invest, their money goes to the finance company, in exchange for the debenture – which is a contract to pay a rate of interest, and the capital back on maturity. There are no obvious fees, and the return is guaranteed by first ranking debt status (which means that if there are problems they have higher ranking than shareholders in the company in terms of getting the money back).
The finance company lends the capital raised, at a higher interest rate than that which they are paying out on the debenture.
It might be to finance a specific project which will make money, or a building that will generate rental returns and capital growth, or perhaps it is just lent to the public to pay for consumption (holidays, purchases, and the like), trusting that they will repay over time.
The finance company use some of the margin to pay their costs of operation – so there are fees, they just aren’t visible – and the remainder is their profit and reward for the risks they are taking in lending. The average finance company is currently lending at 14.4%, whilst paying investors 8.1%, which provides a margin of 6.3%.
At this point, although your client may believe they have taken on no risks, they have actually taken on plenty.
Lending is risk
The risks involved coalesce around two broad headings – inflationary and solvency.
Regardless of the finance companies activities, they have taken on inflation risk – if the level of general inflation rises, their relative purchasing power diminishes. A rapid rise in inflation could even overtake the return they are receiving. For example, an 8% debenture looks pretty good now, but 15 years ago that would have been less than the level of inflation, and they would have been losing spending power. Over the past decade inflation in this country has fallen to under 3% so the risks of this occurring are small, however inflation, as we shall see later on, is increasing globally.
The other inflationary risk is that when interest rates rise, the ability of the debtors to service their debt to the finance company is less. If they borrowed at 12%, for example, but their rate rises to 15% or more, can they still make repayments?
This is a much greater risk, and tied to the nature of the finance company, and their credit control and debt recovery systems ability. If they have an easy credit policy and have taken on a lot of shaky debt, and there are a lot of defaults on payment, then there could be impacts upon investor returns – a lower rate paid, or capital losses.
Similarly, when the cost of living rises, especially of costs that we have little control over – energy, staple foods, rates, rents, for example – then the ability of people to service their debts is compromised, and again, the investor is placed at risk.
It is important to remember that the finance companies are often the lenders of last resort – the people that borrowers turn to because the banks turned them down. Often this is because the banks saw risk with the particular loan, either in the nature of what the money was for, or in the nature of the borrower – perhaps a poor credit history.
The borrower, on a risky venture, is accepting a higher interest rate from the finance company because they could not get bank loan approval. That higher interest rate makes the success of their venture less likely, and the risks of default greater.
The economic cycle is another important consideration. If the economy slows, one of the casualties is jobs. Most people have debts, be they small or large. The sudden loss, or severe reduction, of income causes hardship to most people.
Repayment of debt is made very difficult, as we have a tendency to borrow up to what we can afford – a drop of income at the margins is keenly felt. In a recession, the increase in debtor defaults is much higher than in more prosperous periods.
The recession risk is particularly evident in property company debentures. Big building projects are often at risk, particularly those that rely upon consumer wealth – a big investment in luxury apartments or retail shopping malls can run into huge problems in a recession, when suddenly the consumer is forced to cut their spending.
While we have been enjoying high economic growth, shopping malls and streets have their full complement of open stores, and housing tenancy rates are high. In an economic slowdown, shops close and aren’t refilled by new ones. Offices, houses and apartments remain vacant, and the building owners and their investors bear the losses.
The names of Chase, Ariadne, and Judgecorp, are still remembered from the last big implosion we experienced in 1987, where investors in those companies did not just suffer a reduced return, but loss of capital.
First-Ranking
A first ranking secured debenture sounds reassuring, but what is it?
It refers to situations where, when a company or a security runs into problems, there is a hierarchy that determines who get first call on the assets. First-ranking does not necessarily mean first in this case. The hierarchy is broadly this:
- Workers and the IRD get first rights to the assets
- Senior debt is next – bank lenders etc. A ‘first-ranking debenture may be classified among these, but may actually be considered to be subordinated debt…
- Subordinated debt – lesser debt holders of the finance company.
- Equity holders in the company.
So, if a finance company debt does run into problems over a particular issue of debt, the label of first-ranking may not mean a lot. The important issue is "what is the security for the debt". Is it secured over real assets that have a known value? Or are the assets backing the debt intangible or realisable.
Make sure you know what first-ranking means in respect of the investment under consideration. In some cases it could mean senior debt, in others, subordinated.
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