Why Marcus Padley is dead wrong on note issues

Research shows our brains can rationalise almost anything, but Greg Hoffman says buying the recent batch of income securities shouldn't be one of them.

Marcus Padley’s writing is often provocative and invariably amusing. But on the current slew of subordinated note issues, he’s advocating a dangerous approach.

You can read it in this column. And Padley put forward much the same sentiments on national TV at the weekend. Here is his view:

‘The catch, of course, is that these issues are academically overpriced. Ask any fixed income purist: he will tell you the equity investors who are buying these notes are not pricing in the equity risk and there are better risk reward ratios on offer elsewhere in the fixed-interest arena.’

He continues; ‘But while these opinions are well reasoned and essentially correct’ - there should be a full stop after that (and he could do without the beginning ‘But’); instead there’s a comma and he barrels in to his specious argument:

‘they are a little too highbrow for the average equity investor. They ignore the fact that a lot of the target audience are simply looking for a better return than term deposits, are unlikely to get a lot of stock, are only going to put a small percentage of their money in them anyway and are probably going to end up with a spread of these notes.’

His view is wrong for at least two reasons. First, ANZ’s expansion of its recent offer from the originally-touted $500m to $1.5bn puts the lie to his view that investors are ‘unlikely to get a lot of stock’. Our banks, in particular, are hungry for capital.

Second, and more importantly, Padley admits that these are mispriced securities but that he’s happy for investors to have a small amount in them. It’s akin to a doctor advising their patients to add a little rat poison to their daily vitamin supplements; ‘look, I know it’s going to hurt you in theory, but don’t worry because it’s only a small amount and you’re taking a lot of other good stuff.’

In this approach Padley demonstrates a lack of understanding of ‘The Fairstar Principle’, a term I coined in October 2007; consistent small wins can disguise the true relationship between risk and reward.

His advice implies ‘we both know it’s not an intelligent investment but you’re unlikely to get caught out.’ And, in more than 9 cases in 10, he’ll be proven right. But it’s the cases where things go wrong that count. And the results can be catastrophic. Just ask those who bought RAMS shares in the July 2007 float.

Back then, brokers were no doubt making the same argument to their clients, ‘sure there’s a risk in funding long-term mortgages with short-term loans but there’s risk in crossing the street, too.’ And two months after stumping up $2.50 apiece for the stock, float investors were staring at a price below the $1 mark as the global financial crisis took hold and RAMS’s short-term funding dried up.

It’s the same error made by those who paid record prices for Greek and Spanish bonds a few years ago – mistaking ‘lower risk’ for ‘negligible risk’. In fact, Nassim Nicholas Taleb (author of Fooled by Randomness and The Black Swan) has made at least a couple of fortunes by playing the other side of most investors’ inability to distinguish a 1-in-100 chance from a 1-in-1,000 chance.

If you’ve been an investor over the past five years and not learned this lesson, I prescribe a month of self-reflection, spent far away from the markets and your own portfolio (‘when you’re in hole, stop digging’, as a wise man once counselled).

For my money, the mispricing of risk was the crucial lesson taught by the global financial crisis. I wonder what Mr Padley learned.

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