Barbara Drury reviews a new type of interest rate security.
What it is Westpac's Halcyon Notes are the latest in a new breed of ASX-listed interest rate securities known as collateralised debt obligations (CDOs) or credit-linked notes. CDOs offer fixed-interest investors higher returns than cash, bonds or more familiar hybrids such as income securities in return for accepting slightly higher risk in an underlying portfolio of corporate debt.
Halcyon Notes are the first CDO to offer a capital guarantee; that is, Westpac guarantees that investors will receive their initial outlay on maturity after six years.
How it works Halcyon Notes are floating rate securities with interest paid quarterly at the 90-day bank bill swap reference rate plus 3.4 per cent. For example, if the initial rate had been set on June 10, the total rate payable to investors for the next quarter would have been 8.91 per cent. The interest rate is then reset at the current market price on each quarterly payment date.
The notes are backed by debt obligations of a global portfolio of 120 companies, with individual credit ratings assessed by Standard & Poors ranging from BBB- to A-. No more than 4 per cent of companies can be BBB- and no more than 5 per cent of the portfolio can be in emerging markets.
Nick Taylor, Westpac's head of structured credit, says Halcyon will invest in companies such as Qantas and Amcor in Australia and Ford, Daimler Chrysler, Maytag, Walt Disney, British Telecom and Sainsbury. A full list with individual credit ratings is set out in the prospectus.
What it costs Halcyon Notes have a face value of $100. The minimum investment is $5000, but there are no entry, exit or management fees. The initial offer comes by a prospectus from Westpac which closes on July 23, and the notes can be traded on the ASX from August 5.
Pros Halcyon Notes offer an instant fixed-interest portfolio diversified across industry groups and countries. The underlying company debt of Halcyon Notes is more risky than First World government bonds, but it is hardly Third World debt.
The initial return from Halcyon Notes of 8.91 per cent compares favourably with other fixed interest investments and CDOs with a higher credit rating (and hence less credit risk). For example, the popular Promina reset preference shares with a BB+ credit rating currently offer 6.9 per cent. Among other CDOs, ABN AMRO's High Yield Fixed Interest Securities (HY-FIs) series 3 have an A+ rating and pay interest of 6.86 per cent, while HY-FI series 4 is BBB- and returns
8.51 per cent.
Steven Wright, the director of fixed interest at ABN AMRO Morgans, says the readily identifiable characteristic of CDOs is the overall credit rating by Standard & Poors. In general, the lower the rating the higher the return.
Although the notes are pitched at investors who intend holding them until maturity, the fact that they are tradeable gives investors the security of being able to cash in their chips if they need to.
Cons The capital guarantee no doubt helps more conservative investors sleep at night, but there is a price to pay for this added security. For starters, the capital return on maturity is capped at face value of $100 per security, so there is no chance of a capital gain. Investors' capital is not at risk, but their income stream is.
If a company in the portfolio defaults on its debt obligation, the interest rate payable to note holders will be reduced by 25 per cent. Interest payments reduce to zero after four company defaults.
The past few years have been marked by high-profile company failures such as Enron, WorldCom and Parmalat, so it would be wrong to assume none of the underlying investments in CDOs will fail.
A further downside for the Halcyon Notes compared with some other CDOs is that they offer no protection amount to absorb losses before they start reducing interest payments.
For example, ABN Amro's HY-FI series 3 and 4 both held Parmalat debt, but ABN Amro absorbed the full amount of the default without reducing payment of interest or principal to investors. By comparison, anyone who had invested directly in Parmalat would have suffered a loss.
Paul Dolan, the manager of investor education at the ASX, says it is imperative that investors read the prospectus of
CDOs to find out the overall credit rating, the companies in the portfolio, if there is any protection amount and how defaults will impact on interest payments and the capital return.
Where it fits in Nick Taylor says the notes are aimed at investors who don't want to put their capital at risk but still want returns better than those from cash or bonds.
An Ord Minnett analyst, Kent Jenson, sees CDOs as suitable for investors with a higher risk tolerance who want to boost the income on the fixed-interest component of their portfolio.
Halcyon is the sixth CDO to seek ASX listing and more are sure to follow. According to Dolan, the ASX fixed-interest market is one of its fastest growing sectors, with 106 interest rate securities listed.
With official interest rates in Australia and the US expected to rise in the next 12 months, Steven Wright says investors will be looking for floating rate securities such as Halcyon which have the ability to lift interest payments as rates rise.
