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Re: [sharechat] Capital Notes

From: "" <>
Date: Thu, 30 Jan 2003 23:29:10 +0000

Hi Pat,
>>Often the secondary market for capital notes is the the
>>place to spot these higher risk capital note investments.
>Yes - I wouldn't consider getting into capital notes on subscription
>but only after they are listed.  I would like to get a feel for the
>market's perception of risk as well as for their liquidity.

In caase you misunderstood me, I didn't mean to cast aspersions on 
all capital notes (bonds), and suggest that you must wait until they 
hit the market to find their true value.  

Indeed, often it is difficult to get in 'on the ground level' 
as you have to be on the good books with your broker to get any 
allocation at all.  But certainly waiting for the notes to show up on 
the secondary market is 'safer', even if you may not get quite the 
yield that the original bondholders/noteholders got.

>>I've looked at getting back into the capital note market at various
>>stages myself, but so far I haven't been able to make the numbers
>>stack up.  The 'problem', if you want to see it that way, is that
>>there are so many high yielding head shares on the New Zealand 
>>market with good prospects.
>In my very *rough* assessment of capital notes vs. yields, I came to
>the conclusion that the capital notes of some good companies have a
>higher yield than the yield from shares (e.g., GPG) whereas in other
>cases it's the other way round (e.g., Sky City).  

You have to be careful using the share dividend yields published in 
the paper.   More often than you might think, shares have paid a 
'special dividend' in the last year, and this is not going to be 
repeated in the current year. Sky City is an example of this.   Sky 
City paid a special dividend of 20cps on 29th November 2002 to go 
with the final dividend of 22.5cps on 4th October 2002 and 15.5c on 
5th April 2002.  So to get the 'forward' yield for Sky City take the 
figure in the paper and multiply it by:

(15.5+22.5) / (15.5+22.5+ 20 ) = 0.655

Footnote: Sky City does have a habit of increasing dividends year on 
year so this calculation might be a little pessimistic.

Nevertheless, historically you are correct Pat.  The dividend yield 
on Sky City shares has been better than the notes.

GPG is a special case in that they have a policy of paying a very low 
dividend, so that they can retain earnings and have shareholder 
wealth increase through capital growth.  GPG noteholders will get a 
good interest income but will not share in any of this capital 

>(putting aside risk) 

That's the point I was making in my original reply.   If you define 
risk as volatility then clearly the shares are more 'risky'.   But to 
my mind this is not a good definition of risk to use for the share 
investor, or the capital note investor.

If I invest capital, the main thing that is important is that I  
get my capital back (hopefully with some appreciation) when it comes 
time to withdraw it.   Daily and monthly volatility doesn't matter at 
all if this is the risk you are worried about.  Your only concern 
should be the difference between the price you went in at, and your 
exit price.

If the share price goes up and down on a daily/monthly  basis 
who cares?  - Providing that is you don't need the money for the 
short term!  But if you do need the money for the short term, you 
shouldn't have it in the sharemarket, or in capital notes, anyway 

I would argue that in the case of a 'high yield share' vs 'a capital 
note' in the same company, the risk is in effect the same.  If the 
company gets into trouble then both shareholders and noteholders will 
do their dough.  There is no need to put aside the question of risk, 
for it is the same for Sky City notes and shares (for all practical 
purposes, as I see it).

>So, I guess, the difference between going with one type 
> versus the other one is the mix of capital vs. income 
> gain buyers would wish (assuming a share price increase).

Actually the difference between whether you get capital gain or 
income depends more on the dividend policy of the company than 
whether you own shares or notes.  A high dividend yielding company 
will generally pay out most of its earnings in dividends.  This means 
not many retained earnings left, so very low share price growth.  

However, should a high yielding share manage to grow its earnings, 
then the shareholder will benefit but the noteholder will not.   
Conversely should a company's earnings reduce then a shareholder 
*might* get their dividend cut, while the noteholder will continue to 
get paid.   In a third scenario, when things get really bad, both the 
shareholder and the noteholder are at risk of losing part or all 
of their capital.

So the main theoretical advantage of being a noteholder is that in 
the wake of a dividend cutting downturn, you would still get paid 
your interest.  But why would you want to invest in a company with a 
poor outlook, and under the threat of a dividend cut, even if you 
were a noteholder?   Wouldn't you be better to invest in a company 
with a good outlook and positive growth?   If you invest in a company 
with a good outlook and a high sustainable dividend yield then it 
seems to me that the shares have more upside risk than notes and the 
same downside risk.  In other words, for high yielding growing 
companies, shares are a better bet than notes - everytime!

Perhaps now you can see why I have many high yielding shares in my 
share portfolio, and no capital notes!

> As long as I hold them until redemption (and the company's ability
> to repay them remains intact) the real loss is  the opportunity cost
> of being locked in a potentially lower yield if economic conditions
> change (e.g., increase in the cash rate, inflation, etc.)

But the whole point of notes vs bank term deposits is that you are 
not locked in to notes.   You can sell notes on the secondary market 
at any time, albeit with the risk of taking a capital loss.  Again I 
see no difference in the opportunity cost of holding shares or notes 
through a downturn.

>While writing my original post, an issue I had in mind was the
>convertibility of the capital notes into shares upon maturity.  If I
>wanted the cash back but the company chooses to issue shares, I
>wonder what would the chances be of not recovering my initial amount
>in full if I sold the shares on the very day of redemption.  I
>wonder if the issue of dilution coupled with the risk of many
>ex-capital note holders selling would push the share price down to a
>level below than that used for the conversion hence not being able
>to recover my full amount.

Yes this is a very real risk.  The solution is to not buy notes that 
automatically convert to shares (read the terms of the 
notes carefully)!  Or sell the notes at least 6 months out on the 
secondary market before 'conversion effect' is fully factored in to 
the note price.   But generally with notes it is a good idea to trade 
them as little as possible, as any brokerage can have a significant 
effect on your annualised income from that note.


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