Colonial Notes: A dark side pitch
Income securities, of which the latest pitch comes in the form of Colonial Subordinated Notes, offer investors two key protections.
First, there’s usually a ‘step-up’ feature. Issuers of these notes usually only want your cash for a few years—although if they can get it cheaply they’ll hang on for as long as possible—and are happy to pay an interest rate of around 3-4% above the 90-day bank bill rate to get it.
After a certain period—say, five years—a step-up date occurs. If the step-up date passes without redemption, the rate paid increases by a pre-defined amount, known as the step-up margin.
Key Points
- Key investor protections from previous issues are utterly absent
- A case study in how the terms of popular products quickly deteriorate
- Proceeds to be used to refinance existing debt, keeping Colonial highly leveraged
The step up rate encourages management to redeem your investment at the end of the period it actually needs the cash for and to reward you, the investor, if it doesn’t.
Prior to the global financial crisis there was a flood of these issues, many covered in a four-part Income securities sweep published on 5 May 08. In recent months, that tide has come back in.
Quality declining
Table 1 shows how the quality of each recent issue has declined. In fact, on page seven of the Colonial Subordinated Notes prospectus, the company helpfully makes a similar comparison.
Since last September, distribution rates have declined, step-up rates have fallen from a meaningful 1% to a meaningless nothing (yes, nothing) and maturity dates have increased.
That process reaches a nadir with Colonial Subordinated Notes, a pitch from the dark side. The distribution rate is yet to be determined, but we estimate it will be around 3%. That would be one of the lowest of recent issues and there is no step-up increase. Let us say that again: There is no step-up increase.
That means should Colonial decide not to redeem after five years, your only compensation is a warm fuzzy feeling at the thought of Colonial being able to reinvest your money in a highly leveraged business for another 20 years. A 25-year maturity is no longer just a risk; it’s a likelihood.
The proposition is essentially this: Lend us—a highly leveraged business—some money, for not very much return, with no incentive to redeem early and a maturity date so far away many of you won’t be around to see it.
Issue | ASX Trading Date | Distribution Rate | Step-up increase | Maturity Date |
---|---|---|---|---|
ANZ CPS 3 | 29-Sep-11 | 6-mth BBR 3.1% | None | 1-Sep-19 |
Woolworths Notes II | 25-Nov-11 | 3-mth BBR 3.25% | 1.0% | 24-Nov-36 |
Origin Energy Notes | 21-Dec-11 | 3-mth BBR 4.0% | 1.0% | 20-Dec-71 |
ANZ Subordinated Notes | 21-Mar-12 | 3-mth BBR 2.75% | None | 14-Jun-22 |
Tabcorp Notes | 23-Mar-12 | 3-mth BBR 4.0% | 0.25% | 22-Mar-37 |
Colonial Subordinated Notes | 29-Mar-12 | 3-mth BBR 3% | None | 31-Mar-37 |
The long maturity date and absence of a step-up rate is enough to run a mile from this issue. But Colonial has thoughtfully provided another reason, just to make sure we get the message.
Typically, income security issuers have the option to defer interest payments. But prior issues had the protection that interest payment deferral could only occur if the company ceased to pay dividends on their ASX-listed ordinary shares.
It’s a significant deterrent to management, especially if they own lots of stock in the business. Ceasing dividend payments usually deals a huge blow to a company’s share price, which is why it’s usually an option of last resort.
Interest deferral
The Colonial Sub Notes also include an option for management to defer interest payments (and cease dividend payments). But in this case the disincentive to defer interest doesn’t carry anywhere near the same weight.
Why? Because Colonial is not a listed company. Instead, it’s a wholly-owned subsidiary of Commonwealth Bank.
Commonwealth Bank’s consolidated profit is completely unaffected by inter-group dividend payments. Colonial could simply cease dividends to its parent and ordinary Commonwealth shareholders would continue to get them. And of course, management need not worry about the impact on their personal wealth because there wouldn't be much of an impact.
If Commonwealth Bank experienced its own financial crisis then ceasing payments on the Colonial Notes would be near the top of the list of things to cut.
But it gets worse. The prospectus discloses that Commonwealth’s group policy is for subsidiaries to pay a dividend equal to their operating profit (section 2.7.4 of the Prospectus). So if the good ship Colonial strikes troubled waters and isn’t making an operating profit, dividends will probably cease. Period.
This is a Clayton’s penalty: One that requires Commonwealth to stop paying itself dividends that weren’t going to be paid anyway. As a deterrent, it has all the teeth of a gummy shark.
You can stop reading now because these details are already more than enough to warrant avoiding this issue like the plague. For a little light entertainment only, let’s quickly look at how the proceeds of this issue will be used.
Refinancing debt
The prospectus discloses they’ll be used to refinance debt owed to Goldman Sachs Australia Pty Ltd or an affiliate (our emphasis added). The $500m being raised won’t be used to grow the business because Colonial needs the cash to pay its bankers back. How reassuring.
Remember, too, that this is a highly geared business with liabilities of $18.5bn against assets of $22.6bn (as per 31 December 2011 pro forma accounts in prospectus).
There’s a bigger question here: Is this hybrid issue a desperate measure to avoid Commonwealth Bank having to stump up more capital? We’ll set that aside for a future article, but the idea of being an investor that helps a business refinance debt when really what’s required is a capital injection holds no appeal.
With Colonial Subordinated Notes, which blithely do away with two key investor protections, the income security market has been sucked into a black hole and re-emerged in a parallel universe where brand names are enough to seduce gullible investors. It really is quite brazen in this regard.
Investors want safety and security from these forms of investment but neither of those terms can be applied to Colonial Subordinated Notes. Instead, the company is relying on the fact that you won’t read the prospectus to find out how lamentable this pitch really is. Don’t fall for it. AVOID.
Postscript: On 24 February the final margin was set at 3.25%, which differs slightly from our estimation of 3.0% in the above review but doesn’t change our opinion of the attractiveness of the security.