Income floats: Heritage, Tatts & Seek

This analyst once worked in the fixed interest department of a large Australian bank. While a colleague was absent, he was given free rein over the corporate bond portfolio of a life insurance division for a few months.

The instructions for running this buy-and-hold portfolio were clear; if any new bond offers came along, ask the risk management department for permission to buy. If it’s good enough for them, it’s good enough for you, he was told.

He gained permission to buy $10m of a new offering from the Brisbane Airtrain development. But he decided, against counsel, to avoid buying blindly and instead took a closer look at the details. Lending to an infrastructure development like Airtrain seemed unnecessarily risky for the return on offer. The earmarked $10m stayed safely in the bank, and he duly copped a serve when his colleague returned to work.

A few years later, Airtrain was bust, which meant the bank was $10m better offer than it might otherwise have been. It was a valuable lesson.

Unlike equities, interest rate securities are generally fixed upside investments at face value, yet their downside is still 100%. To protect yourself, focus on issuers that have little chance of going bust. And make sure you’re receiving adequate reward for any additional risk you take.

It’s with this lesson in mind that your proudly conservative analyst reviews every income security prospectus. It also explains why only two offers have received positive recommendations over the past year, despite the flood of contenders. Let’s take a look at the three income security offers currently clogging up inboxes around Australia.

Heritage Bank Retail Bonds (HSBHB)

These five-year bonds offer a fixed interest rate of 7.25% per annum, or about 1.5% more than the best available rate on a government-guaranteed term deposit of the same duration (offered by Rabobank online). The difference has widened a little (from 1.25%) thanks to this week’s interest rate cut.

This is essentially a plain vanilla bond. Interest payments are neither deferrable nor discretionary, and the offer isn’t stacked with negative fine print. But the extra return over term deposits usually means extra risk, and there’s certainly enough of that here.

First up, Heritage Bank is small. While 120 branches might sound like a lot, this Toowoomba-based bank has a balance sheet barely 1% the size of Commonwealth Bank’s. That balance sheet includes about $8.0bn of assets (mostly home loans) funded by $7.7bn of liabilities (mainly deposits) and just $272m of equity. As with most banks, it’s very highly geared.

Heritage Bank’s business is very focused on home lending; the loan book is 95% mortgages. It’s unlikely that a ‘rogue trader’ will blow up this bank. The bank’s asset portfolio looks ‘well seasoned’ too, with half of the loans having a current loan to valuation ratio (LVR) of less than 60%. Only 14% have an LVR above 80%.

But this reliance on property lending is hardly a great selling point. With a highly geared financial institution, it’s not the average loan that dictates risk in any downturn, but the more marginal ones. We’re concerned about the bank’s exposure to property, particularly with Australia’s high property prices. The concern is compounded by the bank’s focus on one geographic area; nearly two-thirds of loans are in South East Queensland. And while the bonds are technically ‘senior’, the fact that Heritage is mostly funded by customer deposits that rank higher means that the bonds are structurally subordinated to a lot of other liabilities.

Heritage Bank should sail through most downturns relatively unscathed. But for a 1.5% advantage over term deposits, debtholders need to be fairly certain of that. We’re not, so we suggest you let the closing date of 13 June pass without investing. There is a lot of demand for this float, so it may well list at a stag profit. But those focused on the long term should AVOID.

Tatts Bonds (TTSHA)

Tatts Group is offering a seven year bond with a floating rate equal to the 3-month bank bill rate plus a margin of 3.1%. We haven’t combed through the fine detail, but the terms—compulsory, non-deferrable income—look acceptable. As with all genuine bonds, the Tatts Bonds pay interest, so payments won’t be franked.

Our concern here is that there’s inadequate return for the risk. The margin is slim; by way of comparison, competitor Tabcorp Holdings paid a 4.25% margin on a similar bond issue in 2009 (not to be confused with Tabcorp's more recent subordinated notes offering). A margin of 3.1% is acceptable for the highest quality credits. But Tatts, in our opinion, probably doesn’t meet that standard.

The bonds stand next to $1.1bn of existing and equal ranking debts. This compares to book equity of $2.6bn and a market capitalisation of $3.5bn. Tatts is not heavily indebted, but it’s not debt free either. This doesn’t sound so bad, except that a large chunk of the company’s earnings is about to simply disappear, while another division faces structural challenges.

Tatts’ licence to operate 13,750 electronic gaming machines in Victoria expires on 16 August 2012. And the company’s wagering operations face strong competition from online bookies; in 2011 this division’s revenues and profits fell. While the third major division—lotteries—is a decent business, it’s lower margin and will face its own licence expiries over the next decade.

We’d consider lending to Woolworths at this margin. Or we’d consider lending to Tatts if the rate offered was higher, say 4.0% or more. But as it stands, Tatts Bonds offer too little reward for the risks debtholders will bear. Probably the main argument in favour of Tatts Bonds is that it offers income security investors industry diversification away from the typical bank instrument. But we're more selective than that. The offer closes 25 June but we suggest you AVOID.

Seek Subordinated Notes (SEKG)

Calling this instrument a ‘subordinated note’ and claiming it as debt, as the prospectus clearly does, almost certainly follows the letter of the law. But it is awfully close to misleading in a practical sense if not a legal one. Don’t confuse this with other subordinated notes—like National Australia Bank’s recent offer—that have a fixed end date, pay non-discretionary interest and are redeemable only for cash. We suggest you don't think of this instrument as debt at all; ‘preference share’ seems a more apt description.

The securities offer fully franked distributions (which partly explains why they are closer to equity than debt) that gross up to a rate equal to the 180-day bank bill swap rate plus a margin likely to be between 5.0-5.5%. It’s a high margin and, if these ‘subordinated notes’ aren’t converted or redeemed in 2017, the rate will step up by another 2.0%.

But here’s the rub. Distributions are at the absolute discretion of the Seek board, with missed payments being non-cumulative. By executing a 2.0% step up in distributions that it need never pay, the security can be extended indefinitely.

So we have a security that could pay no distributions and might never be repaid. This structure is, in our view, completely untenable. It delivers equity risk without equity upside. History teaches us that any cancellation of the ordinary dividend would probably result in these distributions being cut too. Change of control events are also a risk, as new management teams sometimes sacrifice reputation on the altar of expediency.

During the financial crisis, we knocked back the opportunity to invest in a similar structure issued by a sound business offering potential running yields well in excess of 20%—see Stay out of SITES from 17 Sep 08 (No view – $66.00). While that might have been a mistake of conservatism, we’re definitely not interested in Seek’s preference shares, sorry, ‘subordinated notes’ at a running yield of less than 10%. If you’re going to accept these types of risks, buy the ordinary shares for the potential upside.

While the advertised rate is high, this is a long way from a genuine debt instrument. We’re also quite disappointed—in both the company and the regulator, ASIC—that this is not more clearly stated in the prospectus. This Seek issue deserves a wide berth—AVOID.

We’ll keep searching for attractive income security offers, but this bunch simply doesn’t cut it. For that reason, we don’t intend to cover any of them unless they fall to more attractive prices after listing.