Perpetual Infratil Infrastructure Bonds (PiiBs)

Transcription

1 This page updated December 2012 Perpetual Infratil Infrastructure Bonds (PiiBs) At present Infratil has eight bonds outstanding and a number of bank loans. All but one of these obligations has a market value of at least par. Ie. if Infratil were to offer to buy back the bond or loan it would be required to pay at least 100 cents in the dollar. The exception is the PiiBs which have a current market price of about $0.55 per $1.00 (and a price range over the last year of $0.53 to $0.59). Outlined below is an explanation of why the PiiBs are such a poorly performing security, why Infratil is limited in its ability to bailout PiiB-holders and what may happen in future to their yield and value. Also addressed is the fairness of what has happened, addressing the question of Infratil s moral commitment to assist PiiB-holders What are PiiBs? PiiBs are perpetual, like a share rather than a fixed-maturity bond. Infratil is only obliged to repay them in certain exceptional situations, for instance if Infratil is taken over or is required by its loan covenants to repay all of its debt. The PiiB interest coupon is set each 15 November at 1.5% over the one year bank base rate as at that day. Interest is paid quarterly. Since their issuance, the PiiBs annual coupon rates have been, respectively, 9.00% 10.27% 6.95% 4.97% 4.99% 4.22% 3.97% PiiBs are traded on the NZDX market. Recently the price range has been between $0.59 and $0.53 per $1.00 face value. At a price of $0.55 per $1.00 face value and a coupon of 3.97% they are yielding about 7.2% in the secondary market, but only 3.97% to an original investor. What went wrong? At the time of their issue, investors purchased PiiBs because they were a high yielding bond but as the coupon declined (because the Reserve Bank lowered short term interest rates) this ceased to be the case. PiiB-holders who then wished to sell their PiiBs found that the price had fallen. Today an investor with $20,000 face value of PiiBs will receive $794 of interest over the next year. Sale of those PiiBs at $0.55 per $1.00 of face value would realize $11,000. If that $11,000 were invested in 7% bonds the return would be $770 of interest over the next year. Looked at from the perspective of a new investor contemplating which security to purchase, the cash earnings would be approximately the same on a new issue bond with a 7.2% coupon or buying PiiB a price of $0.55 and receiving a coupon of 3.97%. The PiiB price has moved so that the cash yield has remained roughly in line with the cash yield on bonds with fixed coupons. A number of PiiB-holders have noted that it is unfair that the PiiBs are returning 3.97% while the latest Infratil bonds were issued to yield 6.85%. This may indeed not be fair, but it reflects market realities. Infratil has a contractual obligation to pay a specified coupon rate on the PiiBs; at present that rate is 3.97%. The offer of new bonds is at a rate which investors require to lend for six years on a fixed return basis. Could Infratil bailout the PiiB-holders? The investment performance of the PiiBs has disappointed investors and issuer alike. The nature of the New Zealand capital markets makes it generally undesirable for a company such as Infratil to have a large group of disappointed investors, and the investors advisers who originally recommended the PiiBs would also like to see the lot of their clients improved. Two ways are suggested to bring this about. The PiiBs could be repurchased or the PiiBs could be swapped for a better instrument. These suggestions have not been taken up, for reasons noted below: 1. Repurchase Over the last 4 years, Infratil has repurchased approximately $4 million face-value of PiiBs for about $2.3 million. These repurchases have occurred with the intention of ensuring that the market is liquid. At times in NZ there can be more sellers than buyers for a security and a determined seller could be obliged to accept an absurdly and unfairly low price. To avoid this situation, Infratil has occasionally purchased PiiBs, which has given other investors confidence, and has ensured a relatively orderly market. Naturally it has been suggested that Infratil could (or should) buy back the PiiBs at a much higher price. There are impediments to the Infratil board endorsing this. Today, the market price of a PiiB is $0.55. If Infratil offered to acquire them for $1.00 it would represent a material transfer of value from Infratil s shareholders to its bondholders. In such a situation, would the directors be fulfilling their duty to act in Infratil s best interest? What would be the overall merits of offering to pay $236 million to acquire securities with a market value of $130 million? To date it has not been possible to identify how Infratil s shareholders would benefit to an extent that a substantially above market bid for the PiiBs would be warranted. Any value transfer between one class of Infratil security holders and another must pass the test of leaving neither worse off. The repurchase of PiiBs at an above-market price would be transferring value from shareholders to bondholders rather than creating a win/win. 2. Security swap As an alternative to buying back the PiiBs it has also been suggested that Infratil could offer to swap them, for a conventional fixed-maturity bond, or shares or a mixture of bonds and shares. These proposals suffer from two flaws. They tend to require that Infratil offers a new security (share or bond) worth $1 to repurchase a PiiB worth $0.55, which has the same problem as the repurchase. Or they would entail Infratil offering to issue shares or bonds also worth $0.55 in exchange for the PiiBs, but these suggestions are either very complex or something holders of PiiBs can do themselves. Ie there is nothing to stop a PiiB-holder today selling their PiiBs and using the proceeds to buy other shares or bonds. Someone once said "for every complex question there is often a simple answer, but it is usually wrong"; that is the predicament created by the PiiBs. But, as noted below, the situation for holders is not hopeless (even if it is very disappointing).

2 What next? As described above, what matters for PiiB-holders is the coupon rate (the market price matters when holders wish to sell out and cease to be holders). If the coupon rate rises it will provide a better return, and it may also result in an increase in the PiiB market price. As shown below (see the graph) a low coupon and a low price have gone hand in hand, and probably the converse will also be true when the coupon rises. What coupon can PiiB-holders expect in future? The current financial environment does not allow confident forecasts as economists and analysts are struggling to anticipate developments. With that proviso, the following table shows the forecasts of the one year bank rate plus 1.5% of the major NZ banks and the Reserve Bank are forecasting (as at December 2012) for the next two Novembers. Forecasts Bank Base Rate + 1.5% Nov 2013 Nov 2014 Current actual 4.2% 4.6% Reserve Bank 4.5% 4.9% Westpac 4.5% 5.0% ANZ 4.4% 4.8% BNZ 4.9% 6.0% Average 4.5% 5.05% However, as noted above, forecasts have to be taken with a pinch of salt. The last 4 coupon have been 4.97%, 4.99%, 4.22% and 3.97% and back in 2009 when the rate was set at 4.97% almost no one was forecasting rates to remain as low for as long as they have. A year ago the average forecast coupon for the PiiBs from November 2012 was 5.25% as against the actual coupon reset of 3.97%. Even though the banks are forecasting interest rates to rise, they are not forecasting a return to the average levels of the last decade, which would mean a PiiB coupon rate of 7.75%. Even the modest increases forecast may not happen. Today it is possible to fix rates in advance and those rates are the top line of the table; they are lower than the bank forecasts. However, in New Zealand short term interest rates tend to move in line with inflation and when the Reserve Bank becomes concerned about prices rising it is anticipated that interest rates will be lifted. 20% 3 Month Interest Rate & The Annual Rate of Inflation 9% 18% 8% 16% 7% 14% 6% 12% 5% 10% 4% 8% 3% 6% 2% 4% 1% 2% 0% 0% -1% Jan 1990 Jan 1991 Jan 1992 Jan 1993 Jan 1994 Jan 1995 Jan 1996 Jan 1997 Jan 1998 Jan 1999 Jan 2000 Jan 2001 Jan 2002 Jan 2003 Jan 2004 Jan 2005 Jan 2006 Jan 2007 Jan 2008 Jan 2009 Jan 2010 Jan 2011 Jan Day Bill Rate (lhs) Annual Inflation Rate (rhs) If the PiiB coupon rises, will the price follow? It isn t possible to be definitive about what factors could lead to a higher PiiB price, but it is possible to look at the market prices of several PiiB-like securities and to draw an inference that lower coupon rates corresponded with lower bond prices, and hence that maybe vice versa will pertain when rates again rise. The following table itemizes details of a number of bonds which are similar in terms to the PiiBs. Issuer Amount Interest rate terms Infratil $240m Coupon rate reset annually on 15 November at 1.5% over the 1 year swap rate ASB $200m Rate reset annually in November at 1.3% over the 1 year swap rate ASB $350m Rate reset annually in May at 1% over the 1 year swap rate Credit Agricole $250m 10.4% until December 2012 when the Coupon is reset at 1.9% over the 5 year swap rate Fonterra $35m Coupon rate reset annually in July at 1.7% over the 1 year Government Stock rate Origin Energy Contact Finance $200m Rate reset annually in October at 1.5% over the 1 year swap rate Rabobank Nederland $900m Coupon rate reset annually in October at 0.76% over the 1 year swap rate 2

3 The graph below shows the relationship between the one-year bank base rate (the red line) and the market price of three of the bonds listed above. The top, purple, line shows the price of the bonds issued by Rabobank. The blue line is the PiiB price. The green line is the price of the Origin Energy bond. It is apparent that a low base rate (and hence coupon on the bonds) has coincided with lower bond prices. It is probably reasonable to infer that a rising coupon will increase the prices. PiiB Returns From Here? An investor who buys a PiiB today at $0.55 per $1.00 will receive an overall return determined by both the annual coupon rate and the price which they later sell the PiiB. The following table shows a likely range of yields for a three year period from now. To explain the two shaded squares: An unfortunate investor who buys a PiiB today at $0.55,receives the low average coupon over the next three years of 4.25% and sells their bond for $0.50, will have an average return on the money they invest of 4.8%pa. for the three years. A fortunate investor who buys a PiiB today at $0.55 and receives the high average coupon over the next three years of 5.0% and sells their bonds for $0.60, will have an average return of 11.8%pa. for the three years. The actual yield may be well outside of these ranges, but the table shows outcomes consistent with bank forecasts of coupon rates over the period to the end of 2014 and historic PiiB prices. Sale Price After 3 Years Average Coupon 4.2%pa. Average Coupon 4.6%pa. Average Coupon 5.0%pa. Price =$ %pa. 5.5%pa. 6.2%pa. Price=$ %pa. 8.3%pa. 9.1%pa. Price=$ %pa. 11.0%pa 11.8%pa. This is not intended to suggest that investors should buy PiiBs or sell them. It merely shows the two factors (coupon and future price) which set the yield and gives an idea of the likely range. Fairness A number of holders of PiiBs have contacted Infratil to query the low price and coupon. Some people have also asked about the PiiB s relative return. These investors feel they invested in a security for a return over the bank deposit rate, but they are now receiving less than this. Three questions arise from this inquiry. The first is whether in fact the PiiB coupon return is lower than bank deposit rates. Assuming this is the case, the next question must be whether the investors were somehow misled about the issue terms when they purchased the securities. The third question is whether, irrespective of the technical issue terms, Infratil should help out by increasing the PiiB coupon to make it higher than bank deposit rates. PiiBs V. Bank Deposits The following graph shows the bank one-year wholesale base rate (the 1 year swap rate, which is explained further below) and the bank six-months retail deposit rate. It also shows the coupon rate on the PiiBs since they were issued. The wholesale rate is from BNZ, the retail deposit rate is from the Reserve Bank. The green line on the graph is the spread between the wholesale base rate and the retail deposit rate. It clearly illustrates a very fundamental change since the Global Financial Crisis. 3

4 Wholesale Base Rate vs. Retail Deposit Rate % RBNZ, BNZ, Infratil Data source: It is apparent that while all rates have fallen over the last five years, the short-term bank wholesale base rate has fallen more than has the average shortterm bank retail deposit rate. Consequently the PiiB coupon rate, which is based on the wholesale rate, has fallen more than has the retail rate. Today a retail investor could well receive a higher rate on a bank deposit than on the PiiBs. The reasons for this relative change in bank retail and wholesale rates are complicated and are summarised later in this note. Compliance With Legal Obligations 1 Year Swap Rate Six-month term deposit rate Spread PiiB Coupon When the PiiBs were issued Infratil naturally took steps to ensure the issue complied with the law and that investors were not mislead. The issue terms promised investors a margin above the one year swap rate, not bank deposit rates, and the offer documents warn that the price and coupon on the bonds may vary depending on market conditions. It is still, however, fair to now ask Since the issue occurred there have been developments that were not foreseen. Does this have any consequences for the legal efficacy of the issue documents?. Or put simply, things have happened to the price and coupon of the PiiBs which were not anticipated in 2006, do these developments change Infratil s legal obligations to holders of the PiiBs? This was very carefully considered and management concluded that Infratil continues to be in full compliance with the law. The role of the PiiBs Trustee and others involved with the bond issue is worth noting in this context. The Trustee must exercise reasonable diligence to monitor whether or not the PiiBs are in compliance with the Trust Deed and the offer terms. This is not the same as ensuring compliance with securities law, but naturally a Trustee with wide experience of both the law and the terms of different securities would be likely to be aware of legal issues. This is also true of the banks and brokers who arrange and distributed the bonds. None of these parties has raised any issues about the PiiBs compliance with the law. Incidentally, this note and other relevant material placed on the Infratil website has been widely circulated, including to the PiiBs Trustee and brokers. The Spirit of Compliance: To Balance Windfalls There is word of the law and there is spirit of the law and a number of requests have been received by Infratil along the lines of it isn t fair, Infratil has had a windfall gain because of unexpected developments, Infratil has an obligation to look at the spirit of the transaction and address PiiB-holders returns. Assessing compliance with the spirit of an agreement is hard because different participants may have quite different understandings and objectives. It isn t possible for Infratil management to put themselves in the shoes of the disappointed PiiB-holders, but it is possible to comment on the issue of windfalls and also on the point made in a letter from a share broker Investors expect to be paid 1.5% more than bank rates and do not accept that bank rates means a wholesale rate that clearly was never intended to result in coupon rates lower than bank [retail deposit] rates Infratil has not had a windfall gain from the PiiBs. This may be disputed by a PiiB-holder who has seen coupon and price fall and may assume I have lost, ergo you have gained. The reality is more complex because for Infratil the PiiB issue was one of many interrelated transactions as the funds were applied to various purposes and interest rates swaps were used to convert the funding to a fixed cost. As the saying goes, You could not step twice into the same river; for other waters are ever flowing on to you. It is not possible to go back and unpick one stitch of many, not least because of the nature of a company s obligations. Ultimately a company s many transactions result in gains and losses with the net benefit/cost taken by shareholders who would balk at a retrospective reallocation. 4

5 The Spirit of Compliance: To Meet Investor Expectations The second in the spirit issue is as set out in the broker letter; that investors expected a return higher than they were offered on bank deposits and Infratil should meet that expectation by increasing the PiiB coupon or restating its terms to be 1.5% over retail deposit rates as opposed to 1.5% over wholesale deposit rates. As noted above, the problem with any assessment of what people hoped for from a transaction is inevitably coloured by individual perspectives and experiences. Investors in the PiiBs may well have expected a different outcome, but it is also fair to note that the last six years have been full of surprises in the finance markets. These surprises can be given a numeric form if they are expressed as spreads between different interest rates. 1. Bank Borrowing Rates From Retail versus Wholesale Lenders Bank retail wholesale %pa. Bank retail deposit rate 6.9% Bank corporate base 7.7% (1.7%pa.) Bank retail deposit rate 4.3% Bank corporate base 2.6% In 2006 when the PiiB issue opened, banks wholesale or corporate one-year base rate was 0.8%pa. higher than the retail deposit rate (so an investor in the PiiBs getting a yield 1.5% over the wholesale rate was therefore receiving 2.3% over the retail deposit rate). Today the corporate rate is 1.7% lower than the retail rate. The 2.5% swing in relativities is a major reason for the PiiBs poor relative performance. In effect, this is the basis of the complaint from the broker quoted above. But as noted below it is by no means the only change in relative prices which has occurred. 2. One-year versus Five-year (Wholesale) 1 year 5 year bank wholesale rate +0.6%pa. Bank one year rate 7.7% Bank five year rate 7.1% (0.5%pa.) Bank one year rate 2.6% Bank five year rate 3.1% In 2006 the bank one-year base rate was higher than the five-year rate. Today the one-year rate is lower than the five-year rate. The relative swing amounts to 1.1%. Today an investor seeking yield will get a higher return from a five-year investment than a one-year one (all other things being equal). Relatively this makes the PiiB s coupon which is reset annually less attractive by 1.1% versus a security which has its coupon reset for five years. 3. Credit Spreads Infratil bond borrowing margin over bank base rates %pa. The margin Infratil offered on the PiiB 3.5%pa. The likely margin Infratil would need to offer on new bonds now Today an issue of long-dated Infratil bonds is likely to require a margin of about 3.5%pa. over the bank wholesale base rate (the swap rate). This is 2.0% higher than the margin on the PiiBs. What the above three-step spread analysis indicates is how the financial market pricing today differs from six years ago. In a purely relative sense an investor in the PiiBs has potentially lost out (in yield terms) by: 2.5% care of bank retail deposit rates rising relative to wholesale rates 1.1% care of short term rates falling further than longer term rates 2.0% care of widening credit spreads on corporate bonds Which still begs the question should Infratil lift the PiiB coupon to be higher than retail bank deposit rates rather than just meeting the documented obligation to pay a coupon higher than the wholesale rate? After exhaustive analysis Infratil s management concluded that it would not be appropriate for Infratil to do so. Over the last six years PiiB-holders have been adversely impacted by at least three factors (as shown above) in each case the change is a consequence of unforeseen market developments which do not reflect Infratil s own circumstances. The crucial disadvantageous change addressed in the broker letter quoted above relates to the relationship between bank wholesale and retail rates. This has come about because a general downgrading of bank credit has required banks to pay more for deposits and because the Reserve Bank requires banks to fund a larger part of their lending from retail deposits. These two factors mean that banks are paying a relatively higher margin for retail deposits. Infratil clearly bears no responsibility for the bank credit contretemps and it has no responsibility to maintain the relationship between the coupon on the PiiBs and the bank retail deposit rates. Summary Since the PiiBs were issued in 2006/7 the financial markets have been significantly disrupted. A great many financial relationships which seemed enduring in 2006 have been recast. These market changes have meant that the PiiB s coupon and secondary market price has fallen markedly. Infratil bears no responsibility for these market changes. However the question was asked if Infratil should nevertheless do something to improve the lot of PiiB-holders. This is a complex issue as any such improvement would involve transferring value from shareholders to PiiB-holders. It was decided that such a transfer was neither practical nor fair. 5

6 Someone contemplating buying or selling the PiiBs should take into account the factors noted above which harmed the PiiB s relative yield: 1. Bank borrowing rates from retail versus wholesale lenders 2. One-year versus Five-year wholesale interest base rate 3. Credit spreads Each of these factors could change in future to either hurt or help the value and returns on the PiiBs. Regrettably it is extremely difficult to provide guidance. The last five years have been full of surprises and the markets may return to pre-crisis terms, or trend somewhere else altogether. Banks provide relatively detailed forecasts of some aspects of the above, in particular the future trend of wholesale rates. But there is little in the way of detailed forecasts of credit spreads and the gap between wholesale and retail borrowing rates. That banks now pay more for retail deposits than they do for wholesale deposits is both a major change in behaviour post the Global Financial Crisis, and something which was not anticipated before the Crisis. As the change reflects a combination of market perceptions of bank credit and central bank regulations it is no surprise that forecasts of future trends are sparse. Appendix: What is the 1 year swap rate? Simply, this is the base rate a company such as Infratil would agree with a bank if borrowing on a fixed rate basis. If today Infratil were to ask one of its banks for a one year fixed rate loan, the bank would probably express the pricing as 1 year swap rate + margin. An explanation of how the rate is determined is more complex and is outlined below. The key point (especially in the context of the UK bank LIBOR scandal) about swap rates is that they are used by commercial borrowers and banks because lenders and borrowers trust them. Details about which banks supply swap rate quotes, and the rules they are obliged to follow when providing swap bids and offers (which are used when the official Swap Rate is set each day), are set out on the NZ Financial Markets Association web site: The more basic question what is an Interest Rate Swap? is addressed with the following example (NB for the sake of simplicity the following omits the roles of bid offer and mid rates): In NZ, bank loans are often priced relative to the bank bill rate. Bank bills are short term securities (6 month or less) and are actively traded in the money market. Today the 3 month bank bill rate is 2.64%. Past rates are available on: A corporate borrower, such as Infratil, may pay a rate on a loan from ANZ priced as Bank Bill +1% with the bill rate reset every three months. (So today the coupon rate on the loan would be 2.64% + 1.0% = 3.64% and in three months the rate would be reset to reflect the then bill rate plus the 1% margin, etc.). The loan may be five years, but the bill rate would be reset every three months. Because Infratil prefers to have its borrowing cost fixed for a number of years rather than just three months, Infratil may swap its floating rate for a fixed rate with a bank (which can differ from the bank providing the loan). The swap could be for the whole five year term of the loan. Under the swap the bank, say BNZ, would pay the interest on Infratil s loan from ANZ and Infratil would pay BNZ a fixed interest amount on the loan. The net effect of this arrangement is that Infratil has a five year loan with a fixed rate. Infratil has swapped from paying Bill + 1% to paying 5 year Swap rate +1%. Of course Infratil could have just borrowed the money from the bank at the fixed rate of 5 year swap rate +1%. The net effect would be the same. 6