AFIC Notes: A stag dilemma

The AFIC notes on fire float review (Subscribe – $100.00) celebrated a true rarity; an income security float where the fine print worked against the issuer and in favour of the investor.

The one unfortunate but necessary characteristic was the discriminating guest list. The offer was only open to existing AFIC shareholders. Unsurprisingly therefore, the notes listed in December at a small stag profit and currently trade at a 5% premium to their $100 issue price.

If you managed to get stock, perhaps you’re wondering what to do now. If not, maybe you’re thinking of buying in. This review will address both those questions, although that first entails a quick discourse on the effect of the purchase price on future returns. Please stay with us; it won’t take long.

With any perpetual security (including ordinary shares) or very long-term fixed interest rate securities, small changes in price make correspondingly small changes to expected annual returns. That’s why, when the right opportunity presents itself, it’s best not to quibble—as Phil Fisher counselled in Common Stocks and Uncommon Profits—or you might miss a bargain.

Shorter-term securities aren’t like that. A small change in price can lead to a much greater change in expected returns. AFIC convertible notes are a case in point.

Today’s buyer handicapped

Let’s assume the ‘free option’ discussed in the float review (and again below) expires worthless. That would mean noteholders receive $100 cash on maturity in February 2017.

Those who invested in the float at $100 per security will have received an overall annual yield to maturity of roughly 6.35%. (Note that the yield to maturity is higher than the security’s annual interest payments of 6.25% because our calculations are compounded annually rather than more frequently, and the first interest payment date occurred just two months after listing.)

Today’s buyer is handicapped. Having invested $105 to receive only $100 in February 2017, on maturity they’re assured a 5% capital loss.

Apportioning this loss against the income to be received over the next five years—most accurately through an internal rate of return calculation as we’ve done here—means that today’s buyer is looking at a more miserly annual yield to maturity of 5.35%.

That’s lower than safer alternatives. Westpac, for example, is currently offering 5.80% on a five-year term deposit, a rate that’s unlikely to be the best offer in the market.

Big bank term deposits are even safer than AFIC Convertible Notes, especially for smaller term deposits covered by the government guarantee. Right now, they also offer a higher yield. That $5 difference in the AFIC Notes’ purchase price makes all the difference between a good and a below average investment.

Not so free

Which brings us nicely to the option, something you don’t get with a term deposit. The original review explained how AFIC noteholders have the right (but not the obligation) to convert their $100 investment into ordinary AFIC shares at a fixed price, subsequently set at $5.0864.

If, over the five-year period, AFIC’s share price rises much above this (only an 18% premium to today’s share price of $4.31), then noteholders will start accruing capital gains in lockstep with ordinary shareholders.

But if today’s investor buys AFIC notes on a yield to maturity of 5.35% instead of a technically safer but otherwise similar term deposit at a higher rate of 5.8%, then can we really consider the attached option ‘free’?

No. Instead, it’s something the purchaser pays for by accepting a lower annual yield.

A mind-boggling option pricing model isn’t necessary (if you’ve just opened up Excel, you can stop sweating now). Commonsense is a more than adequate stand-in. For conservative income investors, 5.8% in the hand is probably better than a slightly-riskier 5.35% and an option of unknown worth in the bush.

No longer compelling

All of which means AFIC notes are no longer a compelling, low-risk opportunity for fresh investment.

That $5 gap isn’t so great as to warrant selling though; the attached option is worth something today, even if its final value is unknowable and potentially zilch. Call it stereotyping, but we suspect most AFIC noteholders sit firmly in the buy-and-hold camp anyway.

At around $100 (adjusted for accrued but unpaid interest payments) we’d again happily recommend AFIC Convertible Notes for fresh investment for the same reasons we endorsed the initial float.

And at a higher price—around $110 (similarly adjusted for interest payments and assuming no substantial changes to the implied value of the attached option)—existing noteholders might consider taking their profits and putting them to work elsewhere. Expect another review in the event of either.

In the meantime, AFIC Convertible Notes are a very comfortable HOLD.