Question from Rob Prugue: Bank hybrids and other investment securities are NOT term deposits. Corporate notes, convertibles and debt issued by many banks are being touted by some as akin to term deposit. Oh really? Hybrids and convertibles as term deposits? If they sincerely believe this to be true, what on earth are they doing advising. And if they know it’s false, why don’t they just say so?
Here’s a perspective from Philip Bayley, Principal, ADCM Services. This comment first appeared in Banking Day.
Why has the listed bond market developed as a risky, high yield market?
The vast majority of the funds being invested in high yield notes are coming out of self-managed superannuation funds that are intended to provide for beneficiaries’ retirement. Should regulators be concerned that the listed bonds are a risky, high yield market? The answer is yes.
The regulators, issuers and other market participants are well aware of the risks posed by the notes and yet some mums and dads can’t get enough. Earlier this month, NAB launched its second converting preference share issue for the year and, just as with the first issue in March, demand was sufficient to allow NAB to double the size of the issue to A$1.5 billion.
What is the attraction of a hybrid security that offers all the downside risks of equity for little reward? Is there an element of mis-selling in the marketing of these instruments?
Much emphasis is placed on the instruments offering a dividend of 325bps over the bank bill rate, in the case of the NAB CPS II. This sounds like a high yield but at current bank bill rates, it means an annual return of about 4% plus franking credits.
Do mums and dads realise that they are being targetted for these offers, because institutional investors would demand a margin over the bank bill rate that would be closer to twice the size of the one on offer? Institutional investors have a much clearer understanding of the equity-like risks that the instruments entail.
Clearly, retail investors do not have access to the same level of information available to institutional investors and for the most part, do not have the same level of understanding. In NAB’s case, many mums and dads simply perceive the converting preference shares to be a better yielding alternative to a term deposit.
Retail investors rely to varying degrees on the recommendations of their financial planners and advisors, who in the case of the former at least, rely on the research houses to provide research and recommendations on these instruments. And while institutional investors have access to credit ratings to help inform their investment decisions, very few issuers of listed bonds have chosen to have their bonds rated.
In fact, credit ratings have been actively avoided by issuers of listed notes. The wholesale market demands credit ratings but in the listed market issuers see ratings as an unnecessary expense and who wants to highlight the risks involved anyway?
This attitude is underlined by the spate of unrated, unlisted bonds that have been issued to supposedly ‘sophisticated investors’ this year. This is something else that the financial system inquiry will no doubt be concerned with, in relation to the development of the corporate bond market.
Sophisticated investors receive none of the prospectus provision protections provided to retail investors. Under regulation 6D.2.03 of the Corporations Act a sophisticated investor is defined as a person with net assets of A$2.5 million or more or whose gross annual income in the last two years has been at least A$250,000, as certified by their accountant.
These days neither test is particularly hard to meet, and who says they know anything about investing anyway? Having assets or a good income does not an investment professional make.
Do the sophisticated investors who have bought the unrated, unlisted bonds offered realise the credit quality of each of the issuers would likely be assessed as being in the single B category by any of the three major credit rating agencies? This is well into junk territory, so let’s hope the yield on the bonds provides sufficient compensation for the risk.
The Financial System Inquiry needs to consider ways to increase the flow of reliable information to investors, both at the time of making the investment decision and afterwards. Ideally, this information will be made freely available to investors by the information providers, and only by those providers that have joined the Financial Ombudsman Service.
Such a requirement would go a long way towards to creating well-informed investors, ‘sophisticated’ or not, and promote a listed corporate bond market in the form originally intended.