KEY POINTS:
The Bridgecorp receivership has dominated the personal financial news space over the last couple of weeks as commentators reflect on the fact that the return of over $500 million of funds of 18,000 investors is now uncertain.
Half a billion dollars is a big hit to the savings
of a country of 4 million people. However what hasn't had much discussion thus far is how could it happen?
Why would 18,000 people invest $500 million in a relatively small finance company when the media has been full of warnings about the sector for years?
Indeed this column wrote of finance company debentures in 2005: are Mum and Dad inadvertently financing the clients that the mainstream banks avoid?
The truth is that in many cases the introduction of Bridgecorp to Mum and Dad came from their independent financial adviser.
One consequence of the Bridgecorp disaster is that the typical business model of the local financial planning industry, whereby clients take on lots of risk and the adviser takes the risk premium, is under threat.
The simple facts are that with an all-up annual fee structure of 2-3 per cent a year there is no place for sensible low-risk, fixed-interest investments, like government bonds yielding just 7-8 per cent, in Mum and Dad's managed portfolio. With the sort of fee structure typical of local financial planners, higher risk is the order of the day: Bridgecorp and their other risky confederates are the only viable fixed-interest option in a 3 per cent a year fee world. Risky debentures further differentiate themselves by offering regular trailing fees to financial planners. No hope of this sort of handout from government stock or Kiwi bonds.
One message of the Bridgecorp fiasco to financial planners, platform providers and fund managers is loud and clear: get your costs down, the party is over.
It is early days yet but the courts may also be asked to determine whether four or five finance company debentures can reasonably constitute the fixed-interest component of a balanced portfolio for Mum and Dad in Remuera.
That such a strategy is grossly imprudent was obvious before the meltdowns of Bridgecorp, Provincial etc. In contrast the balanced portfolios of your average pension funds or unit trust typically have 40 per cent of their funds in genuinely low-risk, fixed- interest type securities. Finance company debentures are conspicuous by their absence from most professionally balanced portfolios.
Why? There are a number of good reasons, in addition to not getting your money back.
Foremost among these is that the fixed-interest element of a portfolio should lower overall volatility in that when stocks fall in value ahead of a downturn in the economy low-risk bonds frequently rise in value. However, when the fixed-interest markets foresee tough times on the horizon, interest rates often bifurcate. All this means is that some interest rates rise and some decline, depending on how reliable the borrowing entity is perceived to be.
In a more severe economic climate the interest rates on risk-free debt like government stock will fall (and the value of the bonds rise) whereas more risky borrowers, like your average property developer, have to pay more because the probability of their default has increased.
So higher-risk bonds like finance company debentures have little value in diversifying a portfolio of equities. At the first sign of trouble they change their spots and act like shares themselves. Back in the 1930s when the stockmarket plunged and banks went bust, 3 per cent US Government bond prices surged, whereas the prices of risky bonds plummeted.
A further compelling reason not to own finance company debt is the lack of a liquid secondary market: in other words it is easier to get into than out of.
The significance of this relates to pricing: when the Government issues debt it is priced with reference to the secondary market. With little or no secondary market in finance company debt, who is to say what the right interest rate is? In addition there is very little institutional investment, meaning that risk may be mispriced.
Lastly the theory and commonsense says that you should widely diversify your risky assets. Investors can choose from any number of share funds with hundreds of stocks in them rather than own just a couple of individual shares.
But there is no such diversified option available in the debenture market.
In practice the financial planner recommends four or five different debentures and that is it, you cross your fingers and hope for the best.
But the numbers don't add up even if you own 20 debentures: with a 10 per cent interest rate and just one out of the 20 firms going bust means that your return is halved to 5 per cent - below what you could get in the bank.
Bridgecorp is a disaster, for its 18,000 investors and for those in the NZ investment industry who channelled clients funds into Bridgecorp debentures, not because they were appropriate, not because they were good value, but because their returns were high enough to sustain their own unrealistic fee structures.
Local investors lucky enough to have avoided Bridgecorp should remain wary.
There will be more bullets to dodge: turbulence from a full-scale CDO (collateralised debt obligations) and subprime debt (mortgage) meltdown in the US would sweep away structured credit portfolios from Cape Reinga to Bluff.
* Brent Sheather is a Whakatane-based investment adviser
