Debenture Debacle

Sydney Morning Herald

Wednesday April 11, 2007

By Barbara Drury

Investors who want safety should look no further than their bank.

Debentures play an important role in investors' financial armoury, but as the recent Fincorp collapse highlighted, the higher the interest rate, the more investors leave themselves open to a fatal blow.

Some Fincorp investors at the March 30 creditors' meeting told of losing their life savings and others admitted losing hundreds of thousands of dollars. This is not only financially devastating for those individuals, many of them retirees unable to kick-start a new savings plan, but also deeply troubling.

Three of the golden rules of investment are diversification, balance and an adequate trade-off between the risk taken and the potential rewards.

Institutional investors secured against Fincorp's properties are likely to get all their money back while small investors in Fincorp debentures - unsecured notes and the misleadingly named First Ranking Notes - will be lucky to get 30 cents in the dollar, if they get anything.

"If they had put one quarter of their money in Fincorp and the rest with institutions offering 6 to 7 per cent [interest] they would reduce their risk of losing all their money," says Laura Menschik, the managing director of WLM Financial Services.

Fincorp was offering investors 9.75 per cent a year. One-year fixed-term rates for debentures range from about 5.5 per cent for bank-owned financiers such as Esanda to about 9 per cent, compared with a top rate of 6.4 per cent for a 12-month bank term deposit.

As an indicator of unacceptable risk, the Australian Securities and Investments Commission advises investors to avoid debentures with a yield 3 per cent or more above term deposit rates.

HIGH-RISK DEVELOPMENTS

Debentures are essentially a loan to a financier. Investors lend money in return for interest and (hopefully) receive their original investment back at the end of the loan term.

Despite the Fincorp crash, Menschik says debentures play a useful role as part of the fixed interest, or defensive portion, of a balanced portfolio.

They are especially popular with people who want to park money in the short to medium term, perhaps from the sale of shares or property, for a fixed rate of return.

Or that's the theory.

Unfortunately, not all debentures are secured against real property and not all investors are treated equally in the event of financial collapse. Most of the high-yield debentures that have caused investors so much grief have been on-lent by the issuer to related companies for property development.

Tony Lewis, of fixed interest specialist Lewis Securities, says most high-yield debentures probably pay too little for the level of risk they entail.

He steers clear of high-yield debentures, preferring established issuers such as Esanda, CBFC and Elderslie which have balanced asset portfolios for slightly lower returns. "It all comes back to balance and spread," he says.

One of the problems for investors is that debentures are not independently rated, as managed funds are, or extensively researched.

IMPORTANCE OF RATINGS

Andrew Willink, managing director of Cannex, says his group does its own investigation of issuers included in its rate tables, although he stresses that inclusion is not a recommendation. (Investors can compare products at www.ratecity.com.au, which uses Cannex data.)

Fincorp was included in the Cannex tables until it ran into problems with the securities watchdog ASIC (see page 8). It stopped Fincorp from using potentially misleading advertising with wording such as "secure", "certainty" and "peace of mind through a First Ranking Charge". Lewis believes it should have acted sooner to stop the most recent issues.

Willink says investors should check the debenture prospectus to see whether the money raised is secured by a first mortgage, the company is profitable and has an independent credit rating from Standard & Poor's, Moody's or Fitch.

Cannex also looks for a track record and a portfolio that's balanced geographically and in terms of residential and commercial property.

Jim Stening, managing director of FIIG Securities, says investors should look at the underlying investments, how easily they can be realised and if loans are being made to related companies.

"If you are lending on a second or third mortgage it's not as satisfactory as a pool of first mortgages with a low loan-to-valuation ratio," says Stening, who says investors can also take some comfort if the trustee is "from the top end of town".

Lewis says a company with high-quality property can borrow funds at 7 per cent from the bank while second-rate borrowers go to the general public via newspaper and radio ads. "It's a recipe for disaster," he says.

Lewis also suggests having a close look at property valuations.

In its 2004 survey of high-yield debentures, ASIC found valuations were often carried out on a "value as if complete" basis when there is no guarantee the development will be worth the stated value if and when it is completed.

Other problems unearthed by ASIC's study were a lack of disclosure about funds being on-lent to related companies and a failure to disclose that some of these funds were not recoverable.

HOUSE OF CARDS

ASIC also found instances where money invested with debenture issuers is on-lent to developers who don't have an income stream to pay interest on the loan. Instead, an amount representing interest is added to their loan, referred to as the capitalisation of interest.

In those cases, interest payments to investors are paid from cash raised from new investors. The house of cards topples over if the development is not profitable.

ASIC's consumer website, www.fido.asic.gov.au, is a good place to look for warnings about on-the-nose investments.

Menschik says beginners who can't afford (or don't wish) to pay for advice should start their search for fixed-interest investments at their own bank and then compare its products, rates and terms with those of competitors.

Once investors are more confident, Menschik says, they could start looking at managed products such as fixed-interest funds, which offer diversity for as little as a $2000 minimum investment. Higher up the risk-return scale are high-yield funds which might include a mix of assets such as mortgages, listed property and hybrid securities.

Listed property trusts, also prized for their income plus the potential for capital growth, are readily tradeable.

FIIG issues its own debentures under the Diverseport name for a minimum investment of $20,000.

The debentures offer a diversified portfolio which ranges from AAA to -BBB rated corporate bonds and fixed-interest funds, with no more than 10 per cent allocated to high-risk securities.

Stening says one reason high-yield debentures are so popular is that there has been a lack of access to fixed-interest products between government bonds and high-yield debentures, although this is changing.

"The amount in short-term investments in Australia is staggering because that's what people want," Stening says.

But as the Fincorp experience shows, the quick fix may not be all it's cracked up to be.

© 2007 Sydney Morning Herald

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