August 04 newsletter
We decided to update our information on debentures,
because of a recurring comment in the marketplace which goes something
like this: "it's not a matter of if a finance company goes
belly up, it's just a matter of when".
We thought it might be a good opportunity to cut through the
marketing hype to point out a few things that you should consider
when assessing your debenture investment.
The first step is to understand what these finance companies
are all about. Essentially, they borrow funds from you, the investor,
and then lend those funds on to borrowers. They make their money
by charging a higher interest rate to the borrowers than they
pay to you. They stay in business by ensuring that their borrowers
can repay the loans, so that, in turn, they can repay the sum
of money you invested.
There are about 30 finance companies belonging to the Financial
Services Federation, and even more that don't. You can expect
an enormous variety in what they do, how big they are and, ultimately,
how able they are to protect your capital and pay the interest
they promise.
We recommend that investors supplement the information provided
by their adviser with a little of their own research.
The two key documents to find, read and understand, are the investment
statement and the prospectus.
Some key things to consider include:
- The size of the company. In this case, bigger really is probably
better. For example, a bigger company is more likely to have
specialists in assessing the quality of the customers they're
lending money to. Bigger companies are also more able to diversify
their risk across a greater number of customers.
- Who they lend money to. Different companies lend within different
industries. the Shape of Money suggests that finance companies
which lend to property developers are a much more risky proposition
than finance companies which, for instance, lend to established
trucking companies.
- Their BondWatch
rating. This is a free service which uses publicly available
information to rate the various finance companies. "BondWatch
uses a ratings template that assesses 47 different criteria
for bond issues, including such things as the history and ownership
of issuers, governance and management structures, as well as
balance sheet and financial analysis. There are eight levels
in the ratings table with each level indicating a different
tier of assessed risk."
- Understand what the security really means. For example, if
you are investing in unsecured notes, there is no security over
the company's assets. Security can range from charges against
either specific assets or general assets of the company. Other
options include insurance arrangements which are designed to
offer protection, in the event that the loans are not repaid
to the finance company.
- What else is in the fine print? Some investments will give
the finance company the option to "call" the investment.
This means that they can repay your investment before it is
due to mature. This could happen when interest rates fall, meaning
that you suddenly lose the nice income stream you had been enjoying.
What does the Shape of Money recommend?
- Spread your investment across more than one finance company.
- If your investment timeframe is greater than three years,
we suggest considering a managed fund that specialises in fixed
interest investments. Yes, you do pay a management fee,
but you also diversify your risk and get the experts to make
the decisions for you.
- We believe it is better to forgo a few percent of interest
to protect 100 percent of your capital.
In summary, if you decide to invest directly, we recommend that
you read the investment statement and the prospectus and, at the
very least, carefully consider the above points.
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