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 Timbercorp's fall reverberates - Eureka Report article 
 

Timbercorp's fall reverberates

By Scott Francis
April 24, 2009

PORTFOLIO POINT: Timbercorp going into administration is a sobering reminder to investors of the relationship between risk and reward.

Timbercorp, the company behind many tax-based agricultural schemes, announced to the stockmarket yesterday (Thursday) it would be entering voluntary administration, with current debt of $586 million, net debt of $903 million and net assets of $595 million.

This will affect many people in the investment landscape. Those investors who hold investments in Timbercorp schemes will no doubt be feeling somewhat anxious - and perhaps the commission-based financial advisers who recommended the scheme will also be a little nervous. Put simply, the lack of historical returns from Australian agricultural schemes makes it an asset class that, in my opinion, is highly speculative. All the up-front tax benefits in the world make no sense if the final investment return does not add up.

We don't know yet how these managed investments will fare through the process of Timbercorp's administration - and there is no suggestion at this stage that these investment schemes are at risk.

But investors in the ASX listed stock and in Timbercorp bonds - specifically Timbercorp hybrid notes - now face losing much of their money, if not all of it.

The Eureka Report looked in more detail at one of these notes, TIMHB, in July last year, considering issues such as the lack of credit rating, the lack of liquidity and the subordinated (lower ranking) nature of the notes. The conclusion was that they were "unsuitable in a portfolio for those who see the fixed-interest portion of their portfolio as being the reliable high quality part of the portfolio that lets them sleep soundly at night."

Just this week, Jim Stening (see Timbercorp hybrids may reward the brave) looked at what he described as "extremely speculative" Timbercorp fixed interest bonds (double-check?) as a possible investment opportunity as a play on the Timbercorp assets.

What can we learn from the collapse of these Timbercorp fixed interest investments, particularly in light of investors seemingly increased appetite for fixed interest investments, and the rush of companies to issue fixed interest investments to raise capital?

I think there are three key issues for investors to understand:

  • The role that a credit rating place in a fixed interest offering;
  • Why a "subordinate" offering carries extra risks.
  • Why risk and return really are related.

Credit rating

The first thing to understand is that Timbercorp notes were "unrated". Winston Churchill is credited with saying that, "Democracy is the worst form of government, except for all the others". I feel the same way talking about credit ratings. On the one hand, we are in the midst of a global economic slowdown and financial crisis caused, at least in part, by credit rating agencies "misrating" mortgage-related debt. On the other, the ratings agencies have a significant history of providing investors with information about fixed interest investment risk through their ratings.

ASIC has particularly focused on "unlisted" (not listed on the ASX) and "unrated" (without a credit rating) investments, following the collapse of investments such as Fincorp and Westpoint - neither of which had credit ratings.

Here's a table of other ASX-listed hybrid notes that are unrated.

nUnrated ASX hybrids
Description
ASX
SRating
MRating
FRating
Myer Notes 10.1938% 15Mar13
MYFG
NR
NR
NR
Timbercorp Orchard Trust 9% 15Dec10 
TODHA
NR
NR
NR
ACCU Subdebt 9% 31Jul15 
ACDHC
NR
NR
NR
Timbercorp 8.9% 01Dec10
TIMHB
NR
NR
NR
Capral Aluminium 10% 29Mar12
CAAG
NR
NR
NR
Bendigo Bank Perpetual
BENPA
NR
NR
NR
Becton Property Group Convertible
BECG
NR
NR
NR
Bank of Queensland Reset Pref Shares
BOQPA
NR
NR
NR
CMI Limited Converting Preference Shares
CMIPC
NR
NR
NR
Great Southern Plantations TREES3
GTPGB
NR
NR
NR
Multiplex SITES
MXUPA
NR
NR
NR
Babcock & Brown Subordinated Notes
BNBG
NR
NR
NR
Futuris Corporation Convertible
FCLPA
NR
NR
NR
Paperlinx SPS Trust
PXUPA
NR
NR
NR
BBI EPS Ltd
BEPPA
NR
NR
NR
TAPS Trust
TTXPA
NR
NR
NR
Seven Network Perpetual
SEVPC
NR
NR
NR
Ramsay Health Care Perpetual
RHCPA
NR
NR
NR
Transpacific Perpetual
TPAPA
NR
NR
NR
Bendigo Bank Stepup Preference Shares
BENPC
NR
NR
NR
Dexus RENTS Trust
DXRPA
NR
NR
NR
Bendigo Bank Convertible
BENPB
NR
NR
NR
Gunns Convertible Preference Shares
GNSPA
NR
NR
NR
Timbercorp Convertible 30Nov11
TIMG
NR
NR
NR


Source: FIIG Securities


Credit ratings offer a specific recommendation about the likelihood that an issuer (such as Timbercorp) will be able to make the promised payments to an investor. Having a AAA Standard & Poor's rating means the issuer is extremely likely to make the payment, through to ratings lower than BBB, which are "non-investment grade". An issue that does not carry a rating becomes extremely difficult for an investor to assess: how can an individual investor make an assessment of the business, assets and cash flow of a company like Timbercorp, and then assess how likely they are to receive their promised payments?

Subordinate ranking

The TIMHB fixed interest investment I reviewed was described in the 2005 prospectus as being an "unsecured note".
Unsecured notes or "promissory notes" are simply a promise by the company to make a series of payments to you. They do not have the strength of a normal "corporate bond" investment, where corporate bond holders are at the front of the queue to be repaid if the company defaults. Investors in unsecured notes are likely to rank well down the chain of people seeking money in the case that the company goes into liquidation.

This means that in a default/liquidation strategy, an investor in an unsecured note is far less likely to see any money as compared to an investor in a corporate bond. In the case of Timbercorp it has been reported that ANZ "is appropriately provided for its exposure to Timbercorp" - if ANZ is expecting to make a loss on their loans then things are looking grim for unsecured investors.

Promises had been made about the assets backing the Timbercorp fixed interest investments; however, the inability of Timbercorp to sell any assets when needed must bring into question these valuations.

Risk and reward must be related

At a time when stockmarkets have provided a period of extremely poor returns, it is not surprising that investors look for more "secure", fixed interest-style investments. Unfortunately, the desire for safety has lured investors into some very poor quality investments, including weak offerings in the hybrid notes market. If a note is unrated, this is not a good start, whatever a financial planner may tell you.

The bottom line is this: if a borrower is forced to borrow money at a higher rate of interest, they are only doing it for one reason: because no one will lend it to them at a lower rate. As an investor you make decisions about who you lend your money to. If you are lending to someone willing to borrow and pay a high rate of interest it is not because they are really nice people, it is because no one will lend them money at a lower rate.

Conclusion

The rush to the safety of fixed interest investments should be tempered with an understanding of their risks. The current Timbercorp situation is a reminder of the potential dangers of some fixed interest investments, dangers that lurk below the attractive promise of a fixed income return and the repayment of capital at the end of the term.

Scott Francis' articles in the Eureka Report 

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