Brian Gaynor: High-interest addicts run risk of a fall

The sharp drop in interest rates is having an enormous impact on investment trends around the world. The low rates are forcing investors to look for alternatives to fixed-interest securities and they are pouring money into residential housing and sharemarkets.

In Sydney, retirees congregate outside the stock exchange watching their fortunes ebb and flow on the big electronic screen.

In the United States, investors are glued to CNBC and other financial networks as they try to do better than the 0.89 per cent on offer for six-month Treasury bonds.

New Zealand is an exception to this rule. The local residential housing market is buoyant but most investors, particularly the elderly, are avoiding the sharemarket because of the poor performance of many of our major companies and inadequate regulatory enforcement.

New Zealand investors, particularly retirees, are addicted to high-interest-rate, high-risk, fixed-interest investments.

There has been a spate of capital note issues in recent years and, based on last week's Weekend Business, at least 25 organisations will be advertising high-yield fixed-interest investments in this weekend's edition. There should also be a number of ads for property-related seminars and investments.

On Thursday, ABN-Amro Craigs registered a prospectus for new high-yield fixed-income securities called HY-FIs. These are offering indicative yields of 7 per cent (with a Standard & Poor's credit rating of AA minus) and 8.75 per cent (with a Standard & Poor's rating of BBB).

A spokesperson for the Australian branch of ABN-Amro, which is arranging the issue, said HY-FIs had been aimed at wholesale investors across the Tasman but none at individuals because they were more interested in the sharemarket.

He said that these securities were being marketed to individual investors in New Zealand because they had a more sophisticated attitude towards fixed-interest investments.

He should have said that HY-FIs were being launched here because investors have a limited interest in the New Zealand sharemarket and are enamoured with high-yielding, fixed-interest securities.

The same trend is evident in managed fund statistics. Australians have 34.3 per cent of their total managed funds invested through the ASX and 31.9 per cent in domestic fixed interest.

We have only 13.7 per cent of our managed funds invested through the NZX but have 38.4 per cent in domestic fixed interest. (New Zealand investors have 35.2 per cent of their managed funds overseas compared with only 18.9 per cent in Australia.)

The New Zealand finance company sector has been one of the main beneficiaries of the low-interest-rate environment and investors' preference for fixed-interest securities.

These companies offer relatively high rates on deposits and there has been strong demand from borrowers, mainly property and consumer spending related.

A study by Clive Thorp of the Reserve Bank showed that total assets of 45 major finance companies have more than doubled, from $4.5 billion to $9.2 billion, since 1998. This growth is extremely impressive but the finance company sector is still tiny compared with the registered banks, which have total assets of $190 billion.

Thorp believes there are three main reasons finance companies have grown so strongly:

* The decline in interest rates and a shift in investor preference from equities to fixed interest have ensured a steady supply of deposits for finance companies paying relatively high interest rates.

* A strong demand for borrowings, particularly for residential housing and apartment construction.

* Finance companies have been able to attract skilled staff formerly employed by banks, make good use of computer technology and be more flexible and responsive than the banks to market conditions.

Unlike the registered banks, most of our largest finance companies are New Zealand owned. But UDC, the largest, is owned by ANZ Bank, and AGC was sold by Westpac last year and is now known as GE Finance and Insurance.

As the attached table shows, the two fastest-growing large companies are Elders Finance and Bridgecorp.

Elders Finance is part of the Hanover Group, which is in the limelight after becoming involved in the battle to control Tower.

Hanover, which typifies the new breed of aggressive finance groups, is a 50:50 joint venture between Mark Hotchin and Eric Watson. It acquired Elders Finance in 1999, Nationwide Finance in 2001 and FAI Finance in January 2002.

United Finance was established last year and the Hotchin/Watson group has several other asset management and investment companies.

Total group assets have grown from just $100 million in 1999 to $450 million in 2001 and are now over $1 billion.

Elders Finance is the group's biggest operation, representing about 50 per cent of Hanover's assets. In the past 18 months its lending to the commercial and residential property sector has increased from 46.4 per cent to 59.2 per cent of total lending.

Elders Finance also has many related party loans. As at December 31, these loans totalled $91.2 million, or 218 per cent of shareholders equity, compared with $43.9 million, or 172 per cent of equity, 18 months earlier.

The other Hanover finance companies are Nationwide Finance (total assets of $92 million), United Finance ($49 million) and FAI Finance ($22 million). Nationwide specialises in lending to the transport and property sectors, United focuses on retail, consumer and education and FAI on the retail and consumer sectors.

Several characteristics apply to many of the rapidly growing finance companies. These include:

* Investment statements are readily available, particularly on websites, but up-to-date prospectuses are more difficult to obtain.

* Financial information is often dated, particularly for the rapidly growing finance companies.

Prospectuses acquired from head offices this week had the following balance dates: Elders Finance (December 2002), Nationwide Finance (August 2002), United Finance (June 2002), FAI Finance (June 2002), Pacific Retail Finance (September 2002) and Noel Leeming Financial Services (March 2003). Pacific Retail Group, an Eric Watson-controlled listed company, owns the latter two.

* Some finance companies have a large amount of related-party loans and no independent directors. The four Hanover finance companies have the same three directors, Kerry Finnigan, Mark Hotchin and Maurice Kidd. Finnigan is chief executive of the Hanover Group and Hotchin and Kidd represent the two major shareholders.

* Many of the fast-growing companies have a big exposure to property developments. Elders Finance has 36.4 per cent of its lending to the property development sector and Bridgecorp has a 54.4 per cent exposure to residential development.

* Many finance companies have most of their borrowings maturing within two years. This could cause problems if property developers are unable to meet their financial commitments.

The important message about high- interest-rate securities is that they are not risk-free. This is particularly true in New Zealand as we have a regulatory regime that emphasises disclosure over enforcement.

The objective of our regime is for prospectuses to contain a full disclosure of risks, and enforcement agencies have limited powers and resources.

In other words there should be a host of warning signs at the top of the cliff but there is no ambulance at the bottom if someone falls over.

With this in mind, fixed-interest investors should search for warning signs in prospectuses and make sure they have a well-diversified portfolio in order to minimise their risk.