Woolies delivers a security winner

ANZ's CPS3 recent offer - tilted too far in favour of the issuer - contravened this maxim. Woolworths Notes II, blessed with a refreshing lack of unfair fine print, isn't perfect but is good enough to find a place in a genuinely conservative portfolio.

Notes II will pay interest quarterly at a rate equal to the 90-day bank bill rate (BBR) plus a margin of 3.25 per cent (versus 3.1 per cent over the 180-day BBR for CPS3).

The 90-day BBR is currently 4.7 per cent. If interest rates hold steady for the Notes II term (which they won't), noteholders will receive quarterly interest payments that add up to 7.95 per cent a year. Not bad.

Of course, rates fluctuate (although the margin itself is fixed for the next five years). As with at-call bank accounts, noteholders will benefit from rising rates but suffer if they fall.

That is where the similarities end. The ANZ CPS3 offer is equity disguised as debt. In a disaster scenario, it delivers disastrous, equity-like losses. Not so with Notes II. This is genuine debt.

Yes, it's unsecured and subordinated, which means it ranks below most of Woolworths' other debts, but compared with preference shares, such as CPS3, it's a lot more palatable.

Paid in cash

Importantly, these notes are debt liabilities of a conservatively geared company. Woolworths' operating profit is 10 times greater than its interest expenses, suggesting it is among the most bulletproof companies in the land. Few borrowers are as safe as this.

The development of its Masters Home Improvement business will increase its debt load, which partly explains this issue, but it remains a conservative and prudent company.

In an ideal world, if a company missed just one interest payment, that would constitute a default. A trustee could then seize and sell its assets on behalf of debt holders.

Neither of these securities has this feature. Instead, interest payments are optional, at the discretion of the board and, in CPS3's case, the Australian Prudential Regulation Authority, too. But there's a difference.

Unlike the non-cumulative CPS3 securities, if Woolworths skips interest payments - which it can do for a maximum of five years - they must eventually be repaid. The missed payments also accrue interest for the period they are outstanding.

Notes II should pay interest in full and on time. Interest will be permanently skipped only if Woolworths goes bust - an extremely unlikely event. ANZ, in contrast, has an incentive to permanently skip distributions on CPS3 in a tough banking environment.

Then there's the matter of how you actually get paid.

Interest on Notes II is paid wholly in cash. CPS3 holders, on the other hand, receive a mix of cash and franking credits that constitute the headline dividend return. Cash is better. Again, Notes II wins out.

At maturity

What about repayment when the security matures?

ANZ CPS3 will more than likely convert into $100 worth of ordinary ANZ shares at a slim 1 per cent discount to the volume weighted average price of ANZ shares over the 20 business days leading up to September 1, 2019.

Stocks can be highly volatile over any four-week period and a 1 per cent discount isn't sufficient compensation for this risk. Woolworths Notes II is repayable in cash, so there's no conversion risk at all.

While the official maturity date of Notes II is in 2036, repayment will probably take place on the so-called "step up date" of November 24, 2016, at which point Woolworths will either redeem the notes for $100 cash or incur a 1 per cent "step up" in the interest margin.

If it decides not to redeem in 2016, the margin will increase from 3.25 per cent to 4.25 per cent for the remainder of the notes' existence. (Woolworths retains the right to redeem any time between 2016 and 2036.) That's attractive additional compensation if it decides not to redeem early.

Woolworths Notes II is not the perfect conservative investment.

It's riskier than most cash accounts and term deposits and there's no implied government guarantee here. But on almost all counts, it whips the recent ANZ CPS3 offering.

Woolies Notes II offers lower risk than ordinary Woolworths shares, with little chance of permanent capital loss. Unlike CPS3, Notes II doesn't switch to equity at exactly the time you don't want it to, either.

Nathan Bell is research director at Intelligent Investor, intelligent investor.com.au. This article contains general investment advice only (under AFSL 282288).