2008 article:Not all hybrid notes are made the same: In my last...

2008 article:

Not all hybrid notes are made the same: In my last Close up column I examined the recent issue of a fixed interest security from Suncorp-Metway. This week I want to zone in on a note that has been trading for some time, the Timbercorp bond (TIMHB).

What was the offer? First, it will be useful to go back to launch of the note. The offer was made at the end of 2005 for investments for a five-year period, to December 1, 2010, offering investors a return of 8.9% fixed, paid quarterly for the term. The face value of the bond was $100.

At the end of 2005 8.9% was a strong income return. The Reserve Bank cash rate was 5.5%, so Timbercorp's note represented a 3.4% premium to the prevailing cash rate.

Of course, because it is a fixed rate bond, the interest rates have not risen in line with changes in the cash rate. The opposite to fixed rate notes are variable rate notes - such as the Suncorp-Metway investment - which has an interest rate that responds to the cash rate.

The basic structure of a bond is that it offers investors a series of known interest payments (in this case 8.9% a year) and the return of the capital (in this case $100) at a set time in the future (in this case December 2010)

What is the opportunity now?

Timbercorp shares are now trading at $82. This makes the annual interest payments of $8.88 ($2.22 a quarter), equal to a 10.8% income yield.

On December 1, 2010, the principal of the bond ($100) will be repaid. This means people who invest now will see their $82 increase in value to $100 over the 30 months until the bonds mature.

The security of the offer

TIMHB bonds are unrated, and are described in the 2005 prospectus as being an unsecured note. There is no corporate rating of the issue. This is a major difference between the Suncorp-Metway offer, which had an A- Standard & Poor's rating.

In the absence of such a rating, it becomes more difficult for an investor to assess the risk of the bond issuer, Timbercorp, being able to meet the income and capital payments to the bond.

Since issuing the bond, Timbercorp shares have fallen in value from about $3 to about 82.5¢. Although this does not directly impact the TIMHB holders, it does show that it has been a difficult period for the parent company, which has clearly been hit by the changes in tax-deductibility rulings for some agricultural investment schemes.

Given that an investor at the moment would expect to receive an ongoing income return of 10.8% and a 30-month increase in capital of 22% then the total expected return is nearly 20% a year.

This is an extraordinary return for a fixed-interest investment, and is explained away by risk.

The bonds are unrated, unsecured notes. This is much different from the Suncorp-Metway example, where the issue did carry an S&P rating, and fitted behind depositors if a claim was made.

There is the institutional risk that Timbercorp could possibly in the future be unable to make some payments related to the bonds. Given the difficult environment

A ?Junk Bond' is the name given to high yield, non investment grade bonds. It reflects the speculative nature of such an investment. My views are that the fixed interest and cash sectors of portfolios should be high credit quality and well diversified; an investment in TIMHB satisfies neither of these criteria.

Unsecured notes
‘Notes issued by finance companies, usually for periods ranging from three months to three years, offering higher rates of interest than a debenture of the same maturity but lacking the security of a debenture’.

NJ