KEY POINTS:
The property market claimed another victim this week with the suspension of the $242 million Tower MortgagePlus Fund. Tower has joined a long list of major organisations, including ING and Macquarie, with poorly performing funds that were sold to the public as relatively moderate- to low-risk investments.
What's
gone wrong? Why have moderate- to low-risk products, which are managed by well-known investment power houses, turned out to be such poor investments? ING (NZ), which is 51 per cent owned by the Dutch giant ING and 49 per cent by ANZ Bank, promoted and manages the ING Diversified Yield Fund and the ING Regular Yield Fund, which were both suspended on March 12.
ING Diversified Yield Fund is a complex structure that is managed by ING (NZ) through Australia with all of its investments, other than cash, held in a wholly-owned Cook Islands subsidiary. This was supposed to be a tax efficient structure for New Zealand investors but the latest prospectus noted that if a July 2005 Australian Tax Office ruling were to stand the Fund would have a 46.5 per cent Australian tax rate.
The Fund's objective is to outperform the New Zealand 90-day Bank Bill rate by 2 per cent (after tax and fees) over a rolling 12-month period. Distributions were paid quarterly and were automatically reinvested in additional units.
The fund invested in Collateralised Debt Obligations (CDOs), which are securitised debt instruments that contain corporate debt (loans or bonds) and asset backed securities (residential mortgages).
ING Diversified Yield Fund had an average CDO credit rating target of BBB but is doubtful that many of the mum and dad investors realised that these ratings have limited value.
The problem with credit ratings is that they only assess the ability of the borrower to repay loans; they don't attempt to determine the price of a security should the investor wish to sell before the maturity date.
Thus a credit agency is like a building inspector who tells you that your house is structurally sound but he or she doesn't forecast its sale price.
Many investors and their advisers seemed to be unaware that CDOs and other structured products experience relatively large price falls in credit market downturns.
The problem with ING Diversified Yield Fund was that a large number of investors wanted to redeem their units - total funds have fallen from $592 million in mid-2007 to $353 million - as the value of the CDOs held by the fund dropped sharply.
Thus there were three basic problems with ING Diversified Yield Fund:
* The investment strategy was too risky and the full extent of these risks were not communicated to investors.
* The investment strategy was inappropriate for a closed-end fund (investors can redeem their units at any time) because its CDO portfolio would be highly illiquid in a credit market downturn.
* ING's communication on the structure and the contents of the portfolio has been extremely poor.
The investment objective of the ING Regular Income Fund, which was aimed at low- to medium-risk investors, was to outperform the 90-day Bank Bill rate by 1 per cent (after fees) compared with 2 per cent (after tax and fees) for the Diversified Yield Fund. The Regular Income Fund is also managed through Australia for tax purposes although its investments don't appear to be held by a Cook Island company.
Its CDO-based investment policy seems to be exactly the same as the Diversified Yield Fund although quarterly distributions were paid to a nominated bank account with the option to have this amount reinvested in additional units.
The Regular Income Fund faced the same problem as the other ING fund. Its total value has declined from $247 million to $167 million since mid-2007 and ING had little option but to suspend redemptions.
The net asset value (NAV) of the two ING funds is now well below their 100 cents issue price (see table). It is difficult to know when investors in the two funds will get their money back as ING hasn't issued a public statement since March 12.
Macquarie New Zealand Fortress Notes were listed on the NZDX in May 2005 after raising $29 million from the public. It is a closed end structure that doesn't mature until May 2012.
This is a complex investment product, promoted by Macquarie Bank, which invests in unlisted notes issued by a Cayman Islands entity. The return is linked to a leveraged portfolio of US dollar denominated Senior Loans and the New Zealand bank bill rate. Senior Loans are low ranking corporate debt with a Standard & Poor's credit rating of BB+ and lower.
The objective of the notes is to deliver an annual return of at least 4.5 per cent above the New Zealand 90-day Bank Bill rate.
The Fortress Notes, which are an exceptionally high-risk leveraged investment, have been hammered by the credit market crisis with its net asset value plunging from 100 cents at issue to just 31.6 cents on February 29.
But investors received good news on Monday when it was announced that the borrowing facility to invest in the leveraged portfolio of Senior Loans had been refinanced. This means that investors have a better chance of getting their money back when the notes mature in 2012. However, no interest payments will be paid to New Zealand investors until the new financing has been repaid and this may not be before the Notes mature.
The Fortress Notes are a high-risk product and it is fortunate that the promoters only raised $29 million, well short of the $75 million target.
The Tower MortgagePlus Fund, a closed fund with redemptions available after giving 30-day notice, is classified as a low-risk fund. Its objective is "to preserve capital and provide a competitive income return on a quarterly basis by investing in a portfolio of mortgages on residential, commercial and rural properties".
The problem is that the MortgagePlus Fund no longer offers a competitive return as it paid an annualised interest rate of 8.3 per cent in December quarter and 7 per cent in the March quarter, significantly lower than current bank deposit rates.
Redemptions have increased because of the uncompetitive returns and the situation has been compounded by the relatively illiquid characteristic of its mortgage portfolio. In addition 9.1 per cent of mortgages by value are in arrears for more than 30 days.
The fund will be liquidated with the first capital repayment within 30 days and quarterly thereafter.
Tower is unable to predict how much will be returned to investors, when it will be returned and whether any further interest will be paid.
Tower MortgagePlus used to be a well-run fund but it has been adversely affected by the more competitive interest rates being offered by the big banks and the downturn in property.
It demonstrates the risks associated with any financial institution or investment product that lends long but borrows or accepts investors' money on a short-term basis.
Tower MortgagePlus has produced consistently good returns since 1990 but its lend long/borrow short structure has not survived the severe downturn in credit markets.
Disclosure of interest: Brian Gaynor is an executive director of Milford Asset Management.
bgaynor@milfordasset.com
