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 Fixed Yields Can Be Costly - Eureka Report Article 


October 13, 2006

Fixed yields can be costly
By Scott Francis

PORTFOLIO POINT: The returns for some fixed-interest products are sometimes only slightly better than cash, and might carry more risk than many investors imagine.


Fixed-interest returns disappointed again in the latest fund returns to June 30, with many fixed-interest investors returning less than cash after fund managers extracted their fees. It's no surprise then to see private investors looking at wider options in the search for better returns in the fixed-interest sector. But do investors realise the risks they are taking to get returns that are often only marginally better than cash?

Our article today from Satyajit Das looks at issues that surround the rise of collatoralised debt obligations (CDOs). Seeing as CDOs are generally promoted as a fixed-interest investment, and given the distortion over recent times as to what exactly defines a fixed-interest investment, it is worth starting this article by returning to the traditional definition as to what a fixed-interest investment has been.


Traditional fixed-interest investments

Traditional fixed-interest investments are bonds issued by banks, companies or governments. The bond is an agreement that the investor will lend their capital to the issuer of the bond in exchange for a regular and known series of cash flows, and the return of the capital at an agreed point in time.

For example, an investor might have $100,000 that they wish to invest in a bond. They can buy a five-year Bank of Queensland bond that is paying them 6% a year interest. This interest can be paid either quarterly or annually. At the end of the five years they receive their $100,000 back.

Two key characteristics of traditional bonds reduce their risk for investors. First, bond holders receive their agreed interest payments before shareholders receive any dividends. That is, if the earnings of the company fall sharply, the bond holders receive their interest payments before dividends go out to shareholders. Similarly, if the company collapses completely, such as Enron or World Com, bond holders have the first claim on the assets. Both of these characteristics mean that the position of a bond holder is less risky than that of a shareholder.


CDOs

One of the most popular variations on traditional bonds are CDOs ? collateralised debt obligations ? where investors take a bundled package of debt paying "above average" interest rates. Two of the most popular CDOs in the local market are Nexus products from Deutsche Bank and the Mahogany products from Grange Securites.

Mahogany has earlier this year issued a second series of listed notes; these notes are offering a yield of 9.2%, well above the cash rate of 6%. Is it a good deal?

Early on in the prospectus we get some great news. Under "fees" in the summary section we find out that there are no entry fees, ongoing fees or exit fees. Surely this means there are no fees? Not quite.

At the back of the prospectus we see that total fees on the expected $50,000,000 issue runs to $3 million. That is an effective fee of 6% of the value of the offer . nice work if you can get it. Most of this fee, $2 million, is paid to Grange securities, with a provision for them to take a further 4% of applications above the $50,000,000.

An important point in our article from Satyajit Das is that the portfolio underlying the CDOs is in fact invested in the derivatives market, rather than directly into the portfolio of bonds. This quote from the Mahogany prospectus shows that this is indeed the case:

The issuer typically gains exposure to the entities through derivative contracts that reference the portfolio.

What this means is that investors are not part owner of a portfolio of company bonds, as the concept of a CDO implies at first glance. They are actually part-owners of a portfolio of credit derivatives.

With any product of this nature most investors would reasonably ask two questions: How likely am I to get my money back? How likely am I to receive appropriate interest payments along the way? The prospectus says the promoters expect to receive an AA rating from Standard & Poor's relating to the capital of the issue, with a "not rated" for the interest payments. This implies that the return of your capital is quite secure, but your interest payments, the core value proposition of the product, is not rated.


Unsecured notes

Which brings us to the proliferation of heavily advertised unsecured notes. Like higher yielding CDOs, these products seem to offer the ultimate one-stop investment solution.

I had reason to look at one of the providers, Fincorp, at the request of a client. The Fincorp unsecured notes are currently paying interest at the rate of 10.25% over a five-year term. For investors this looks like a great investment solution: a clearly specified rate of interest well above the cash rate.

A quick read of the prospectus shows that there is a lot more to think about than the 10.25% headline rate before an investor should get involved!

Where is the money invested? Early on, the prospectus lists where money can be invested. There are three areas: cash and short term securities; units in mortgage trusts and property trusts (including where Fincorp group companies are involved); and shares in listed and unlisted companies.

Later in the prospectus, it lists the assets of the Fincorp notes related to its own developments. These were a series of second mortgages held over property developments. Actually, the agreement in place didn't even mean that Fincorp had to bother about little details like paying any of the principal or interest of the loan. It simply capitalised on to the loan, and increases the loan outstanding each time the loan is renegotiated.

The fee structure, which allows Fincorp to retain any earnings above the promised 10.25%, provides more cause for concern. The statement directly from the prospectus is:

Interest rates quoted are net of all fees and charges . Therefore, there are no other ongoing or charges payable by investors.

But the problem is that this particular fee structure provides an incentive for Fincorp to chase the highest possible return on the assets associated with their unsecured notes, as the incentive is for them to make the highest return possible, pay the interest to the investor and then bank the rest ? certainly not behaviour that is in the best interest of the investor.

The details of the loan portfolio (outlined on April 21, 2006) also provide interesting reading. Of the loans at that time $28 million was lent to external borrowers, with $123 million lent to Fincorp Property Development Group. Of the $28 million lent to external borrowers, the vast majority ($24 million) was in first mortgage securities with an average interest rate of 18.4%. The Fincorp loans were primarily for second mortgages ($92 million), which are more risky than first mortgages, with the interest rate they were paying was only 13.9%. (Surely Fincorp are not negotiating preferred interest rate loans for themselves?) Moreover, the external borrowing at a rate of 18.4% implies that the loans there are extremely risky ? only desperate people borrow money at a rate of 18.4%. Keep in mind what Fincorp is doing here: paying interest at a rate of around 10% and then lending it out at 18%.

An investment into a Fincorp unsecured note is not a moderate risk fixed-interest investment. It is an investment into unsecured notes that can be invested in strategies as diverse as unlisted companies, Australian shares and property trusts through to cash, with a significant emphasis on related party loans for property development secured only by second mortgage investments. Not only would I not recommend such an investment to my grandmother, I wouldn't even recommend it to her worst enemy.

One aspect of a traditional fixed-interest investment is that they usually offer some liquidity to a portfolio. In the case of Fincorp, it is clear that the ability to redeem investments prior to maturity will only happen in "exceptional circumstances". Traditional fixed interest investments can usually be traded on a secondary market.


Conclusion

My opinion is that the role of fixed-interest investments in a portfolio is simple: it is there to decrease the overall volatility of a portfolio and to provide a source of liquidity, if needed. The "pseudo-fixed interest" investments discussed in this article don't belong in this space. Their place is in the 5-10% of a portfolio dedicated to "alternate assets". They should never be seen as one-stop investment solutions in their own right. And a bit of a disclaimer that you should not be surprised about: the author has never held, does not currently hold and will never hold an investment in an unsecured note like Fincorp.
Scott Francis' articles in the Eureka Report 

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