Thursday, April 21, 2011

The Quest for Higher Yields

Originally, the title was intended to read “The Chase for Higher Yields”, but I thought that the word “chase” conveyed an element of desperation. Although “desperation” would adequately and concisely reflect the current ground sentiment in that everyone (i.e. the man on the street) is looking for higher yields than what pathetic bank deposits have to offer, I thought “quest” may be more appropriate to describe a large swath of educated, knowledgeable investors who have yet to find the Holy Grail of high yields – a stable bastion of companies or securities which can guarantee a (almost) lifetime of dividends and passive income. And so this post will discuss some of the more recent attempts by companies to not only shore up their Balance Sheet, but to raise funds using very opportunistic methods which attempt to not just capitalize on the public’s hunger for yield, but also to reduce their cost of raising such funds significantly.

Preference Shares

I think enough has been said on the most recent Hyflux issue of Cumulative, non-Convertible, Non-Voting Preference Shares at 6% yield (issued at S$100 per share, “CPS”). Many finance blogs have been abuzz with the CPS as the key characteristic of these CPS are that they are cumulative, which means dividends accrue over the periods if they are not paid out, so that they “accumulate” until they are eventually paid out. This does not, however, mean that they are guaranteed, a point which the corporate brochure took pains to highlight. Many other websites have pointed out the merits and demerits of the CPS, so I will not go into details on that as it has probably been debated to death.

What I would like to do is to highlight salient risks in investing in such securities, and whether an investor should have a much clearer understanding of the underlying risks before taking the plunge. For any firm which issues securities, whether it be equity-based or debt-linked, an investor should read through all prospectuses and comb through the financials of that company as if he were reviewing it to buy its common shares; as the process for screening is essentially the same even though the subordination of the security may be different when it comes to liquidation.

So in the case of securities such as CPS which are a hybrid between equity and debt, one should ask the following pertinent questions:-

1) Why is the company choosing to issue CPS instead of relying on debt financing or a secondary placement? Are there issues with issuance of debt due to existing high gearing and a weak Balance Sheet? For secondary placements, one has to question the attractiveness of a company selling more ordinary shares vis-à-vis the attractiveness of issuing CPS or some other form of preference shares.

2) What are the chances of the company being able to honour its dividend obligations? A close scrutiny of the Company’s Cash Flow Statement (over 5 years, no doubt), mode of business, business model, recent news, industry, competitiveness and market share/position, and future prospects and plans are required in order to make an informed decision. If a company has problems paying a good dividend yield to its ordinary shareholders, then it may likely default on its preference share dividend. Whether this is cumulative or not should not matter – if a company cannot pay then no amount of accumulation will mean anything to the shareholder.

3) Liquidity – Preference shares are usually less liquid as compared to ordinary shares, and therefore the bid-ask spread may be much wider. Poor liquidity is also a result of our stock exchange not being as sophisticated as that of the USA, and may hinder one’s ability to cash out quickly should one need to.

There is probably a longer laundry list of issues to be looked into when it comes to investing in preference shares, but I will leave those for the comments section and move on.

Corporate Bonds for Retail Investors

There has been a recent spate of issuance of corporate bonds catered to retail investors, and this is a surprising development considering bonds were previously reserved for either institutional investors, or accredited (i.e. high net-worth) investors. It all started with Singapore Airlines Limited (“SIA”) issuing S$300 million worth of 5-year bonds paying a coupon rate of 2.15% payable semi-annually back in September 2010. Investors would be able to purchase the bonds in denominations of S$1,000 and the minimum subscription amount is $10,000, which is generally affordable to the masses who are seeking stable, higher yields. At the time, however, the SIA bond was perceived to be paying too low a coupon rate as compared to other investment vehicles such as blue chip dividend yields (around 3-4%) and REITs (which pay on average 5-6%). The issue was a resounding success nonetheless due to SIA’s blue-chip status and paved the way for other companies to issue bonds for the retail public too.

Next up was an underwritten bond offering by another blue-chip company Fraser & Neave Limited (“F&N”); and this was announced on March 16, 2011. This consisted of S$150 million worth of 5-year bonds paying 2.48% per annum (out of which S$50 million was for the public tranche) and S$150 million worth of 7-year bonds paying 3.15% per annum (out of which S$50 million was for the public too). Notice here that the coupon rate for the 5-year bonds is 33 basis points (i.e. 0.33%) higher than those issued by SIA just six months ago, and reflects the fact that the public may require a higher coupon rate to incentivize them to subscribe for the bonds. It could also be due to the fact that more of such issuances were coming up and investors would then be “spoilt for choice”, hence the decision to price the bonds as such. Whatever the case, this still represented extremely cheap debt for both SIA and F&N as the cost of debt was still below 3%. By way of comparison, the dividend yield for F&N on its ordinary shares for FY 2010 was 2.58% (using 17 cents full-year dividend against S$6.58 closing price on November 12, 2010 when it announced its FY 2010 results), so this makes the 5-year bonds slightly cheaper than the cost of equity.

The crux of the issue here is that investors have become so sick of the ultra-low interest rates which banks are offering that they have even turned to such “safe” bonds issued by blue chip companies. These investments can be deemed to be secure enough as the companies involved most likely will be able to honour their coupon obligations, but the investor has to do himself a favour to look for better yields which can exceed inflation (around 4-5%) as the bonds paying less than 3% do not achieve this goal.

Real Estate Investment Trusts (REIT)

In an era of low interest rates such as the present (in fact, all-time low as the SIBOR recently hit 0.33%), investors will have a tendency to flock to REITs as a way of getting higher yield on their investments. These vehicles will traditionally use cheap debt to fund the purchase of properties which have a stable tenant base, thus generating stable (and arguably predictable) cash flows of which a high percentage (usually 80% to 90%) is paid out as dividends to unit-holders. Many REITs will also periodically revalue their properties and in an environment where real-estate prices are rising, this will make the Balance Sheet look good. This combination of low interest rates and rising property values makes REITs very attractive to those looking for high yield investing and many REITs have also issued rights and placed out shares in recent months to capitalize on the low interest rate environment to raise capital to refinance their loans. Other REITs have also proudly proclaimed that they have “locked in” higher tenancy rates for the next 2-3 years, thereby almost guaranteeing the distributions which they have forecast as the debt has no need to be refinanced and hence no extraneous expenses will be incurred.

The problems will, of course, start to pile up once interest rates head north (as they must surely do as part of the reversion to the long-term mean). When interest rates rise, REITs which have to refinance their debt will have to do so at higher interest rates, therefore there will be a need to retain more money to fund such interest payments, leading to lower payouts for unit-holders. Rising interest rates also impact property prices and companies will be more hesitant to borrow to purchase land and build property as the cost of borrowing will increase, and this leads to property values falling. Assuming a steady decrease in asset value, there is always a possibility of being in negative equity. REITs may then have to shore up their Balance Sheets through rights issues, but if their share price is languishing then the dilutive impact to DPU would be even more pronounced, and with tenancy rates falling in a falling market, this could exacerbate the problems.

Thus, while REITs are traditionally seen as “safe havens” for investors to park their money for high yield, do note that there are risks involved as well.

Conclusion

So the quest for higher yield often seems more elusive than attainable, especially in the light of risk factors which may derail the consistent and predictable payments which a security has to offer. As investors, we have to be constantly watchful and wary of where we place our money, for high yield most often does come with associated higher risks. For myself, I opt for decent yield which is sustainable through investing in companies which have a stable business model and a good history of increasing dividends on ordinary shares.

6 comments:

Singapore Man Of Leisure said...

Hi MW,

You have encapsulate the whole risk/reward of yield investing!

Greek bonds are now yielding 13%. No free lunch - those with iron stomachs will go for them.

More conservative bond investors will stick with boring German bonds.

Cheers!

processdriventrading said...

I would be more interested in SIA, Hyflux, and F&N stock rather than the debt. Who cares about investing in this debt when the yield is so low. The point is that the management and advisors of these companies are clearly shareholder-oriented. They are raising cheap cash that they can then use to generate more profit. As long as Hyflux can generate more than 6% return on the money received from those Pref Shares, the common stock will profit from all the excess. Hyflux's Return on Assets stands at 7.43%. F&N paying 2.48% but gets 4.63% ROA. Only question I haven't looked at is how big these debt issuances were relative to their overall assets. probably not very big.

Drizzt said...

In rising interest rare reits might benefit due to better rentals as supply is constrain it does not always mean end of the world

Musicwhiz said...

Hi SMOL,

Yep, there's no free lunch. If you want to accept a very high yield then there would be corresponding risks too.

You're the man for European bonds! I shall remember to ask you in future if I am interested in investing in bonds. Haha.

Regards,
Musicwhiz

Musicwhiz said...

Hi processdriventrading,

I take the perspective that the cash raised would of course be used to further the business, just like any other company taking up bank loans; but the question is the cost to the Company and whether they can maintain a healthy cash inflow to pay off their debt obligations and also service their interest payments.

I also question if ROA is a good measure, as asset levels for high capex companies like Hyflux can fluctuate quite drastically, meaning your denominator can change quite a bit. For me, I will still stick to using ROE, and if you break it down using the Dupont Formula, you can then attribute the ROE to either debt or internal cash flows.

Cheers,
Musicwhiz

Musicwhiz said...

Hi Drizzt,

If interest rates rise, property will usually get depressed and rental rates may moderate. I understand that rental rates usually move in tandem with property valuations; hence if valuations start to drop because of dampened demand for property due to higher rates, then rental rates would also correspondingly fall.

Regards,
Musicwhiz