Analysis: Why NZ corporate bond investors should demand much higher yields

By Bernard Hickey It has been a veritable bond rush and I think it's time to ask if it's too good to be true. New Zealand bond investors have poured more than NZ$2.6 billion into corporate bonds in the last 6 months at interest rates ranging from Auckland City Council's 6% for an AA rated issue to 9% for Fletcher Building Finance's 5 and 7 year unrated bonds. A desperation for any regular return that is better than returns from bank term deposits is driving New Zealand's yield-hungry investors into bond issues they should think long and hard about.  Firstly, these bonds are not guaranteed by the government, whereas money invested in banks, building societies and finance companies is guaranteed until at least October next year. There are obvious uncertainties around whether or how the guarantee might be extended or replaced. But at least it's there now and has worked in its first test with the receivership of Mascot Finance, although taxpayers don't love the idea. Secondly, it's worth asking if the yields justify the risk. Let's look at how international investors are valuing corporate debt right now to see if Mum and Dad investors here are demanding enough for this paper, particularly over such a long time frame.

The iTraxx index for credit default swaps (CDS) for Australian investment grade bonds (BBB minus and above) shows the market 'spread' to insure these bonds is around 430 basis points, near a record high. International investors are saying they are nervous about rising default rates and want a very high premium. US investment grade debt is trading at 250 basis points above the safest type of debt. European junk or sub investment grade debt is trading at 1,170 (11.7%!) above the safest type of debt. Those trading CDS for GE Capital are demanding 1,450 points to insure this AAA rated debt for five years. This means GE Capital and Warren Buffett's Berkshire Hathaway are seen as just as risky as Vietnamese government bonds, according to the New York Times. New Zealanders seem unaware or in denial about the likely deterioration in corporate defaults over the next 5 or so years. Moody's has forecast that some 15% of speculative grade debt is likely to default in coming months, which is worse than the default rates seen during the early 1930s. See more on that here. So how should New Zealand debt issues be priced? Firstly, it's worth looking at the assumptions investors are making when they give their money to a company to look after for 5 years. The investor is assuming that inflation won't rise much, that the company will never miss an interest payment and that it can repay the capital when the bond matures. That implies a high level of comfort about the revenue streams being generated by the company and a high level of comfort about the ability to refinance the debt in five years time. Every bond issuer is different. Fonterra, for example, has a shareholder base which can be 'sacrificed' with lower milk payments if Fonterra gets into trouble. But it does have a lot of debt and faces a collapse in dairy commodity prices. It is also highly dependent on what happens with a volatile currency and what its partners do with its brands (SanLu is one example). There are plenty of risks to be built into the 7.75% return Fonterra offered.  Tower, as another example, is a insurance and funds management company that is dependent at least partially on the performance of financial markets and on natural disasters.  There is plenty of risk to be built into the 8.5% return, particularly when you consider that other financial services companies with much better credit ratings are struggling to raise money offshore at much less than 10%. Currently the 5 year swaps rate in New Zealand is around 4.20% 4.06% and have risen from around 3.7% in the last month. This is a baseline for such corporate rates and is itself based off international rates. It is inconceivable that this swaps rate would be below the 5 year government bond yield or the US Treasury 5 year bond yield. Government bond yields are rising globally as investors strain under a wave of new government bond issuance to pay for huge fiscal stimulus and bank bailout packages. This swaps rate is likely to well above 5% by the end of the year, I believe. So what is an appropriate margin to pay to that swaps rate? Given five year Australian investment grade bonds are currently trading at 430 basis points above swaps then our yield spread to swaps should be at least that high, which would imply a yield of around 8.5% for an investment grade bond at the moment. Of those in our corporate bond rush list, only Tower and Fletcher Building offered a rate as high or higher than that. Both do not carry Standard and Poor's ratings, although Tower has a BBB minus rating from insurance ratings company AM Best. You could argue neither are investment grade. Auckland Airport at 7.25% and Wellington Airport at 7.5% simply did not offer enough return for the risk involved. A collapse in international and domestic tourism would hurt both. Contact Energy's 8% return also underpriced the risk involved, given it had a relatively weak BBB credit rating. New Zealand corporate bond investors should be demanding at least 9% for five year investment grade bonds given inflation and government bond yields are widely expected to rise sharply in the next five years. Speculative or 'junk' bonds should be offering at least 12%, given the risks of default and the lack of alternative funding options. Another thing for investors to consider is the competition for term deposits going on between banks. ASB is offering 5% for 2 years, while ANZ is offering 5.25% for 2 years. BNZ and Westpac are offering 6% for 5 years. See all the rates here.