High yields have tradeoffs
Some
finance firms are securitizing all kinds of things in an effort to offer higher
yields to investors hungry for something more than the 4.5 percent boasted by
top-paying GICs. Other debt obligations are coming to market offering higher
yields with the appearance of safety – but there’s always a catch.
Bonds are
generally backed or “secured” by the issuer’s ability to pay. In the case of Government
of Canada bonds, that’s basically a guarantee since they can always raise taxes
or cut spending in order to increase its cash flow to better service its debt.
Companies in the private sector, however, don’t have this luxury and rely solely on their financial stability and cash flow generation to make good on periodic interest payments and the eventual principal repayment. In other words, most corporate debt – i.e. debentures – is unsecured.
A
securitized bond or debt obligation is one that is backed both by the issuer’s
financial health and its pledge of specific assets. For instance, a
manufacturing firm may issue bonds to build a new plant. In turn, it may simply
pledge the to-be-built facility as security for buyers of the bond. If the firm
fails to pay its scheduled interest, bondholders may eventually force the firm
to sell the new facility to fund the principal repayment.
Securitized
bonds are otherwise known as asset-backed securities (ABS) since there is some
asset “behind” the bond to provide some security in the event of default. The
pledged asset need not be physical in nature. Sometimes, it may simply be a
right to some future cash amount.
While some
may remember this word from grade-nine math, it’s also the name of an old
corporate finance practice - factoring receivables. A key part of a firm’s
financial operations is its ability to collect promptly on its receivables –
i.e. the amount owed to it by its customers.
Firms that
have customers that don’t like to pay on time and/or simply need cash will
often sell away their rights to receive those eventual payments at a discount.
For example, a financing firm may pay twenty cents for each dollar of some
other company’s receivables, if the seller is in desperate need of cash. On the
high end, receivables may be purchased for up to fifty cents on the dollar.
The buyer
then works to squeeze every penny possible out of its newly purchased asset –
usually in the hope of collecting much more than what it paid. This practice is
known as factoring receivables.
I recently
reviewed a bond issued by private financing firm. Their one-page marketing
piece sounded appealing. It boasted an 8 percent annual interest rate; roughly
$1.5 of security for each $1 in bond principal; a portion of which was backed
by government bonds; and a term of three years. Since three-year Government of
Canada bonds offered yields of just 3.8 percent at the time, my “skeptic-radar”
was off the charts.
Here’s how
they did it.
This firm
was very active in factoring receivables. To use simplistic numbers, let’s say
they issued $1 in bonds. They’d typically take $0.20, for instance, and buy $1
of receivables (of which they expected to collect $0.70). They could then take
the remaining $0.80 and invest it in government bonds. And presto – the firm
could claim $1.50 ($0.70 + $0.80) in total assets in security for the $1 in
bond proceeds raised. They could further claim that government guaranteed bonds
secured more than half.
Key
business risks could potentially impact both the interest payments and
principal repayment.
The firm’s
ability to meet those 8% annual payments hinge on successfully collecting an
adequate amount of receivables. That’s the business risk. If they collect just $0.10
rather than the assumed $0.70, there are two consequences. First, interest
payments may be missed. Second, collecting just $0.10 leaves just $0.90 in
total security for each $1 in bond principal.
Further,
this particular offering also charged an annual management fee (a percentage of
total bond proceeds), provided bondholders received their full 8 percent
interest in the year.
In short,
the 8 percent interest was only as good as this company’s operating efficiency.
And if that was really poor, it could even jeopardize the security backing the
bond.
While the
firm may be good at doing its due diligence and might even be successful in its
factoring activities, there is clearly a good deal of risk in the firm’s
operations.
The point
of all this is that if it looks too good to be true, it probably is. A good
starting point is to compare the yield on any type of bond or debenture with
that of bonds issued by the Government
of Canada for the same term. If the yield is significantly higher than that
on government bonds, make sure you’re fully informed of all applicable risks.
Only then will you be able to make a smart investment decision.
See this previous
article on questions to ask when considering new investments.
Next
article: April 18, 2003
Dan Hallett, B.Comm., CFP, CFA is the Senior
Investment Analyst with Sterling
Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, Alberta, and Manitoba.