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September 04 newsletter

the Shape of Money was recently asked to contribute to the Radio New Zealand programme, Your Money.

As a result of research for that programme, some of the views on debentures expressed in last month's newsletter have been refined, as below.

What is the source of the recurring marketplace comment about a potential failure of a finance company?

  • Media examples include the Sunday Star Times 5 September 2004: "the coming fallout in the property market is expected to take its toll among the myriad of finance companies that have sprung up in the past five years."
  • From the first page of stockbroker's McDouall Stuart June 04 report on NZ Finance Companies: "failure of one (or more) finance companies has been tipped".
  • It's also a common topic over morning coffee at industry training days.

Why is the risk to finance companies increasing?

  • Increasing interest rates may impact on borrowers' ability to service their debt,
  • Reduced demand for property may leave some property developers exposed, and
  • Finance companies who have been used to natural increases in business growth may be less careful in assessing the risk of new borrowers as they continue to try to grow their business.

Why is the size of finance companies important?

  • Bigger companies are more likely to have specialists assessing the quality of the loans, and
  • They have more ability to diversify across their lending book.
  • But, investors need to be aware that size should be just one of many considerations.

Why is it important to consider who finance companies lend money to?

  • We suggest that a finance company with a large exposure to property development is more at risk than a company with exposure across a diversified range of industries.
  • A possible default by property developers could be caused by such factors as higher interest rates and falling demand.

What other factors should an investor consider? In addition to the size of the company, who they lend money to, and the geographic distribution of their borrowers, investors should consider:

  • Levels of bad debt and doubtful debt provisions,
  • Level of impaired loans,
  • Profitability levels of the company, and
  • Ownership of companies that might be of some influence - as McDouall Stuart pointed out in their report.

What should investors do?

  1. Seek the assistance of a qualified financial adviser. Ensure that the adviser can demonstrate their use of research, and discloses their remuneration on their recommendations (for example, an adviser may receive 0.25% for a two year investment in a mortgage managed fund, but receive 1% for the same term for a debenture investment).
  2. If you plan to go it alone, read and understand the investment statement and prospectus. Only invest in the company if you understand the investment and are comfortable with it. Perhaps diversify across more than one finance company.
  3. If the investment is for longer than three years, consider the benefits of a fixed interest managed fund instead.
  4. Don't be afraid to accept 1 or 2% less for a nice, safe bank deposit with a double A S&P rating.