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Developers find intelligent life in growing junk bond market

By Campbell McIlroy

Friday 24th March 2000

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Junk bonds, which arrived in this country three years ago, receive bad press because of their name, according to the man who brokered the country's first bond issue.

Managing director of merchant banker UPC Securities Michael Reid organised the first property bond worth $4 million for the Connaught Apartments next to Auckland's Hyatt Kingsgate at a rate of 18% back in 1997.

Since then UPC Securities has brokered most of the junk-bond issues, 20 of an estimated 30, which has raised a total of $200 million in development finance over the past three years from his company alone.

The reason bonds became useful was because it was hard to raise capital in excess of $8 million from private investors in this country and banks would never finance 100% of a development, Mr Reid said.

The only alternative left to cover the shortfall was the retail market of "mum and dad" investors who become bondholders.

The difference between junk bonds and other property investments is the bond holders do not actually own anything.

Syndicators sell an interest in a single property and listed property companies sell shares in their stock of properties but junk bonds are more like a high-risk term deposit with no guarantee you will get your money back. Investors are buying an agreement to lend their money to finance a property development for a set amount of time at a set interest rate.

Current market rates range from 10% to 14% for bonds, and while bond issues are administered by public trustees there are usually no guarantees should the development fall through.

Bond issues are similar to sharemarket floats, as some simply do not last the distance. It came down to who was behind the project, Mr Reid said.

Developers bristle at the emotive term "junk bond" - a nickname which covers a variety of different financial instruments - and prefer other jargon such as preferential bonds, first mortgage bonds or redeemable preference shares.

Whatever they are called the components for investors to consider are the structure of the bond, the track record of the people involved, the level of interest in the end product or the likelihood of sales or leases being secured.

Junk bonds can be structured in a number of ways. The most secure are those taken as first mortgages although there have been only two of this type so far.

Bonds in this position enjoy all the security and rights banks would require for a first mortgage. It put bond issuers in a position of control should anything go wrong, Mr Reid said.

The more common form of junk bond is an unsecured subordinated bond. This is in effect a second mortgage and therefore subordinate to the first mortgage. Should anything go wrong with the project the first mortgagor holds all the cards and bondholders have little or no security.

But once a first mortgage is repaid bond holders assume the position of first mortgage holders.

The best known local bond issue of this type was the $21 million worth of bonds issued for Andrew Krukziener's Auckland Metropolis hotel development.

The issue raised some doubts because of the $120 million first mortgage held by HSBC and a second mortgage of $20 million to Deutsche Bank, both of which ranked ahead of the bonds.

"A $21 million bond behind $120 million left a lot of ground to cover," Mr Reid said.

This week Mr Krukziener said the reaction to his bond issue reflected the nature of doing business in this country, where new things were viewed with a degree of scepticism.

He said he had engaged in this type of financing on a private basis for a number of years and the retail bond market meant that instead of borrowing $5 million from three investors he could get $20 million from 300.

Bonds were an intelligent form of financing and would become more popular as it got harder to achieve good returns from other investments. The main consideration was that of risk versus return, Mr Krukziener said.

The first mortgage to HSBC has now been repaid. Mr Krukziener has undertaken to give the bond holders first-mortgage status as soon as the Deutsche Bank mortgage is retired in about two months although he also said the Deutsche Bank loan might be refinanced.

Mr Krukziener would not specify when the bond would be repaid but did say he would repay it sooner rather than later as it was a more expensive form of financing.

Junk bonds do not usually have to be repaid on a specific date.

It does vary from bond to bond but usually there is a time range within which it must be paid. In the case of the Metropolis the earliest date on which the issuer can repay the bond is June this year and the latest is June 2001.

It appears only one bond issue has been publicly acknowledged to have fallen over - the Ballantyne golf course and retirement resort development in Katikati.

Mr Reid said the reason for its collapse was the developer running out of money to complete the project and, as a result, sales did not go through.

Other sources have suggested it was because there was no "take out" for the project. That means a lack of commitments to sales or secured funds to take out the bonds.

The Katikati project is now understood to have secured an unconditional offer to refinance the development for just under $8 million. If this refinancing package settles bondholders should receive around 95% of their investment back, if not all, but they will not receive any interest.

The take out should be the primary consideration when buying any bond; what likelihood is there that the developer will generate the revenue to take out the bond? That is the case whether the developer is selling apartments or signing tenants to secure a rental stream.

One strong indication of a developer's chances of success is an undertaking by a bank to refinance the project upon completion. This would mean the bank would pay out the bond and take on all debt as a first mortgage once a necessary level of sales or leases have been signed.

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