Woolies Notes II at the checkout

If you own Woolworths Notes II, you're probably focused on income and safety of capital. If you're also of the 'buy and hold until maturity' mentality, you might wish to ignore this recommendation.

As the notes will almost certainly pay every interest bill on time and will be redeemed for $100 cash, most likely in late 2016, you can do so with a high level of reassurance that holding on now won't cost you too much. If not redeemed, the annual interest payments will step up by 1% until whenever the securities are redeemed, potentially as late as 2036.

But we think the current price is high, and it might make sense to sell and redeploy your capital elsewhere, perhaps locking in some attractive, high interest term deposit rates instead.

Arbitrage theory suggests that, all things being equal, the price of an income security should slowly and uniformly rise over the interest period, until the coming interest payment is fairly priced into the stock. Then, suddenly, the price should drop immediately on the day it trades 'ex entitlement' to that distribution.

Real world

Income investors tend to cherish interest payments so, prior to the ex-date, stock prices can run harder than theory suggests, with keen buyers and reluctant sellers playing an irrational game of dibs on the payment.

That seems to be the case with Woolworths Notes II, which has been rising in anticipation of going ex-entitlement a $1.89 quarterly interest payment on 10 May. It last traded at a price of $106.18, presenting a small window from which to leap.

Adjusting for the distribution which will be paid to whomever owns the security at 4pm on 9 May, the underlying price is $104.29—the theoretical price for where the notes should trade on 10 May. But it may well end up a little lower if the stock is correspondingly inflated today.

If you're trying to assess this investment using the methodology outlined in Be roughly right on floating rate yields, then think of today's price as having two components—a small payment of $1.89 for the coming distribution and another of $104.29 for the security itself.

Now let's look at the longer-term returns based on the current security price. Woolies Notes pay interest quarterly based on the three-month bank bill rate plus a margin of 3.25%. In nominal terms, with a bank bill rate of 3.95%, the nominal interest rate is 7.2%. That's a running yield of 6.9%—a number which expresses the income flow as a percentage of the purchase price.

But there's a little more to the story. As today's buyer is paying $104.29 for a security that will be redeemed for just $100, there's a guaranteed future capital loss in the pipeline. If the securities are redeemed in late 2016, the most likely outcome, that loss translates to an almost 1% annual drag on the running yield.

There's another and more accurate route than the 'roughly right' way of calculating yield to maturity (which you might think of as 'total returns'), called a discounted cash flow model. By our calculations, in nominal terms, the notes currently offer a yield to maturity of roughly 6.2%. Expressed more accurately in floating rate terms (by deducting the bank bill rate), the security's yield to maturity is equal to the bank bill rate plus 2.25%. We think that's a little slim.

Alternatives

Some banks are offering 5.8-6.0% on five-year term deposits. While not directly comparable because of their fixed rate nature, a government guarantee (on term deposits smaller than $250,000) and a chance to lock in rates that the Reserve Bank seems determined to lower makes some sense. Woolworths is a very safe, blue chip borrower, but the Federal Government it ain't.

Some online bank savings accounts are offering around 6.0%, although you might have to jump through a few hoops (monthly deposits, no withdrawals etc) to qualify for the highest rate. Like the Woolies Notes II, these rates are likely to rise and fall with official interest rates.

These excellent alternatives—offering similar returns with less risk—may encourage you to lock in a small capital gain and move on. Indeed, that is our preferred course of action, which is why we're moving our recommendation to SELL above $106. We do however recognise that some members may be keen to hold on and are unlikely to ever greatly regret doing so.