Your wealth, Risks exposed in listed debt mart

By Jeannene O'Day

Friday 2nd April 2004

Capital notes or corporate bonds that offer both a reasonable yield and brand name "security" appear attractive in a low-interest-rate world. If you are risk-averse, you probably avoid the higher-yielding securities that carry the baggage of higher risk.

But in the listed debt market, this intuitive approach may not always offer the best risk-adjusted returns. It is relatively illiquid, lacks transparency and is somewhat inefficient.

This is not always a bad thing for all market participants. For a few skillful traders, investors and asset managers, inefficient markets can offer the mis-pricing opportunities that generate greater returns.

Such opportunities exist in the New Zealand market. Rapid Ratings has just released its new NZDX Report, which rates 28 issuers and 58 debt securities (mainly capital notes).

A feature is a risk-return benchmark, based on three independent modelling exercises.

Securities that lie close to the optimal yield curve suggest an appropriate return (current yield) for the level of inves tment risk. Securities above the curve are indicative of overpricing or that its current yield is excessive relative to the level of risk. Those below the curve are indicative of under-pricing or that the current yield is not sufficient for the level of risk.

In the accompanying graph, and in the table, four examples are plotted, all of which have similar maturity. Infratil and Fletcher Building are trading closest to the optimal yield curve.

With a B4 rating, Infratil is borderline investment grade and therefore the current yield of 7.10% appears to be appropriate. Fletcher Building, with a similar risk profile and term, is also positioned on the curve, although the current yield is priced more aggressively, perhaps reflective of a slight difference in its maturity.

At the other end of the scale, Powerco and BIL Finance tell another story. As both are below investment grade, investors might expect a greater return.

BIL has a current yield of 9.00% and Powerco is offering 6.20% both significantly below the optimal yield curve.

Why the disparities? This is due to one or a combination of the following:

* a market focus on brand name rather than risk;

* a security's lack of transparency in relation to its risk profile;

* a security's relative illiquidity; and/or

* a general lack of a scientific benchmark for pricing.

A comparison with the more liquid and transparent equity market offers some insights.

For example, Fletcher Building has nine listed debt securities on the NZDX but only two are positioned along the curve.

Over the past two years, the company has made significant improvements in its financial performance and this has been reflected in the rise of its share price.

The lift in upstream and downstream profitability, as well as improvements in debt service management, leveraging and cost structure, has returned it to investment grade with a B1 rating in both 2002 and 2003 and a positive rating outlook.

This has possibly been factored into some of Fletcher Building's debt securities but perhaps not all.

Comments from our readers

No comments yet