Education Corner - Definitions

  
The actual terms of an investment are detailed in the prospectus. A title only provides a few clues about what to expect. The following is a guide to those expectations but we encourage investors to read the prospectus and to seek input from us before investing.
 
 
Term Deposit - an unsecured loan (investment), typically with a banking organisation that earns a single fixed rate of interest for a fixed term.
 
Usually interest is paid at maturity but regular payments can be arranged which results in lower interest rates being offered. 
 
Deposits cannot be bought or sold prior to maturity. Banks consider applications to break early but if approved will incur fees that cause significant damage to your returns.
 
Debenture - a certificate of acceptance (valuable bearer document) for a loan issued in the borrowing company's name that carries an undertaking that the debenture holder will get a fixed return (interest) and the principal amount repaid when the debenture matures. 
 
Interest can be paid out or compounded.
 
Repayment is backed only by the general creditworthiness of the corporation and not by a mortgage or a lien on any specific property or asset. 
 
NZ finance companies offer the definitions of 'secured' and 'unsecured'. The security they offer is a 'floating charge over the companies assets', meaning most or all assets and not over any specific asset. It provides a reference to where a deposit ranks in the event of winding up a company. Secured investors get repaid first in the event of a default.
 
The word 'Debenture' is the noun (are owing) and the verb is Debere (to owe).

Mortgage - the pledging of a property to a lender as a security for a loan. It is a transfer of an interest in land, from the owner to the mortgage lender, on the condition that this interest will be returned to the owner of the real estate when the terms of the mortgage have been satisfied or performed. In other words, the mortgage is a security or lien for the loan.

The term comes from the old French "dead pledge," apparently meaning that the pledge ends (dies) either when the obligation is fulfilled or the property is taken through foreclosure.

Note that finance companies and banks seek mortgages or liens over property or assets when they lend money.

Further, the NZ Law Dictionary by Hinde & Hinde gives the following wording:

MORTGAGE (Latin, Mortuum vadium, ie, dead  pledge). "A mortgage may be described as a conveyance of or a charge over property created by contract to secure the future payment of money or money's worth, the rights of the mortgagee against the mortgaged property being extinguished on performance of the obligation secured, or enforceable against the property by  appropriate means in case of default." 

The definitions in the Land Transfer Act 1952, s 2, and in the Property Law Act 1952, s 2

The Land Transfer Act 1952, s 100, provides.  A mortgage under this Act shall have effect as security, but shall not operate as a transfer of the estate or interest charged.
 

Bond - a debt security, in which the issuer of a bond owes the holders a debt and is obligated to pay interest (coupons) on defined intervals and to repay the principal at a later date (Maturity).
 
A bond is simply a loan in the form of a security with different terminology: The issuer is equivalent to the borrower, the bond holder is the lender (investor), and the coupon rate is the interest payment.
 
Bonds are usually issued for long term debts and are usually unsecured (do not usually offer lien over specific assets).
 
I didn't find a suitable history but I suspect use of the word bond in finance lies in trade and business agreements (promises, promissory notes).
 
Capital Note - unsecured, subordinated fixed interest debt securities.
 
They have no defined maturity date, instead they have election dates when rollover terms will be offered. If the rollover terms aren't acceptable a note holder may elect to convert to ordinary shares in the company (and sell if desired).
 
The company has the option to pay out cash instead of converting to ordinary shares under such an election. 
 
In virtually all cases since capital note issuance began in NZ (1989 by Fletcher Challenge) the issuers have elected to repay such requests with cash.
 
Preference Share - are unsecured securities, legally recognised as shares (equity) on a balance sheet, and often carry terms that allows conversion to ordinary shares under certain conditions but they are very different from ordinary shares.
 
The economic affect is more like that of bonds making fixed income payments to investors.
 
They are regarded as hybrids of debt and equity. Dividends on preference shares have to be paid before dividends on ordinary shares. Preference shareholders have a higher priority if a company is liquidated than ordinary shareholders, although a lower priority than debt holders.
 
In the case of cumulative preference shares, if the dividend is not paid in full, the unpaid amount is added to the next dividend due. Preference dividends are fixed, so they do not participate in increases in profits as ordinary shareholders do.
 
The effect of these is to make the income stream from preference shares more similar to that from debt investment than that from ordinary shares. Most importantly, fixed dividends are similar to interest payments.
 
Mandatory Convertible Note - is an investment that pays a fixed rate of return for a defined number of years before then converting into ordinary shares of the business. They do not mature and will not be repaid.
 
Secured or Unsecured – If a bond is “secured” it has a specific charge over some asset belonging to the issuer.  If a bond has a “floating charge” it has the security of the net assets of the borrower.  Where a bond is “unsecured” repayment is dependent on the ongoing success of the borrower’s business.
 
The majority of investments are described as unsecured and very few debts offer a lien (possessory security interest) over a specific property or asset. This allows the borrowers to continue to do business without having to always re-organise security pledges over specific assets.
 
In practice, banks and financing companies have claimed specific security over various assets of a business thus taking priority over other lenders who accept an unsecured or second ranking position.
 
Fundamentally investors should focus on the probability of being repaid. This probability includes considering any security held or the underlying strength of the borrower.
 
 
The following describes in general terms the ranking for repayment should a business fail:
 
 

IRD - is first in line for payment of any outstanding taxes.

 

 
 

Senior - debt obligations are the first to be considered for repayment by the receivers or liquidators of an organisation in the event of default. Secured lenders (if any) rank ahead of unsecured lenders.

 

 
Subordinated - debt obligations are considered for repayment after any “Senior” obligations in the event of default by an organisation.  Subordinated interest rate products rank ahead of shares (equity) in a company. There can be differing levels of subordination with a single borrowers balance sheet. For example banks have two different levels of subordination.
 
Shareholders - are last to receive any money from the winding up of a business.
 
Other useful definitions:
 
Perpetual - with respect to investment this means 'no legal maturity'. The borrower has no obligation to repay but may do so when it suits them. Extra yield should be offered in response to an investment demanding this condition. Banks have indicated publicly that they expect to repay their 'perpetual' securities no later than 10 years after they were issued. 
 
Default Risk - The likelihood of a borrower not repaying the funds you have loaned to them (invested). Credit rating agencies try to quantify the probability of default. Financial ,arkets then apply a price (credit margin) for the described risk of default.
 
Credit Margin – An incremental rate of return paid, relative to the risk free rate, to reflect the probability of the borrower being able to meet its payment/repayment obligations.  A government bond represents the risk free rate of return for an equivalent term of investment.
 
Credit Margin Example - NZ Government Bond (credit rating AAA secured against the tax base) maturing on 15 November 2015 offers a return (yield) of 5.50% per annum. A Telecom Bond (credit rating “A” unsecured) maturing on 15 November 2015 offers a return (yield) of 7.00% per annum.
 
Liquidity - The ability to buy and sell the securities you own.  A high level of liquidity means it will be easy to buy or sell the security in the secondary market. 
 
A high level of liquidity results in many buy and sell quotes in the market place.  You can sell most interest rate investments before maturity.  Many investments are listed on the New Zealand Exchange which assists liquidity.
 
Coupon – Is the cash flow paid on the investment.  The gross amount is calculated as “face value x coupon rate”.
 
Yield - The return on the money you have invested is called a yield.  This may differ from the “coupon” rate paid out on an investment. 
 
Bond pricing - A fixed interest investment is valued by using a current market yield to calculate the present value of the cash flows (coupons and maturing amount) yet to be paid out on the investment. 
 
The pricing formula’s are very well known in the market and are available on many calculators including excel spreadsheets.  It is a simple process for you to seek a third party confirmation of pricing if you are unsure of what you are being told by an investment adviser.
 
Duration - The average life of the cash flows of the investment, including interest payments and the maturing investment amount.  This is used to measure the potential value change on the investment as market yields rise or fall.
 
Tax – Resident Withholding Tax is retained against the coupon interest paid on a fixed interest investment.  Secondary market investment pricing may include a premium or discount in the capital price which may have a tax liability or credit.  You should seek professional tax advice with how this should be treated in your tax returns.
 
Initial Public Offer (IPO) – also known as a ‘new issue’ of securities.  A borrower seeks the use of an investor’s funds in return for the pledge to make regular interest payments and return the money lent on the maturity date.  For the public to participate a prospectus and investment statement must be registered with the companies office and then presented to potential investors.  It will detail all information required by the investor including an application form.
 
Allocations in New Issues (IPO) – Your investment adviser should make you aware of new investment issues as they become available and be able to arrange an allocation in these if you require.  If you commit to taking an allocation you are obliged to make the investment.  It is not legally binding but the industry process will fail and thus fail to serve investors if commitments and obligations are not met.  Investors should think carefully about investments before making commitments.
 
Secondary Market Trading – fixed interest investments (securities) trade (change ownership) on the market in a similar way to company shares.  The original investor in a new issue (IPO) investment is not compelled to hold the investment until maturity. 
 
If their circumstances change they can sell the security to a new investor and the purchaser pays cash to the seller.  The security is valued by using a current market yield to calculate the present value of the cash flows yet to be paid out on the investment. 
 
As an investor you can choose to buy fixed interest investment that suit you form the secondary market if no new issue (IPO) is available at the time.
 
Your investment adviser should be able to arrange for prices to buy and sell securities, to book transactions and to ensure they settle as arranged.
 
Brokerage – Service must be paid for or the industry would cease to exist and that would result in unacceptable risks to investors.  Investment advisers/brokers can earn their income for arranging a transaction in two ways.  Add brokerage to the price of the investment purchased or change the price of the investment to gain a profit margin between the buy and sell price.
 
CSN – A Common Shareholder Number.
 
Ideally, each investor will have one CSN only (with a FIN) that is recognised by the major registries Computershare and Link Market Services.
 
FIN – FASTER Identification Number.
 
A four digit number that acts as a security key to holdings in your CSN. A bit like your PIN is the security key for your EFTPOS card (or credit card)
 
Terms and Conditions - The terms of investments are described in the trust deed (indenture) and prospectus. Key terms should be presented in an investment statement. It is very important to understand these terms as they define the risks of the investment on offer. We must understand these risks, and those of the borrower, to define an appropriate return.
 
After distilling all of the information you should reach the conclusion that the name attached to the investment is only a guide to the documentation used and your ranking for repayment in the event of receivership. Investment names are not assessments of the default risk of the business you lent your money to.
 
Therein lies the point, when you lend (invest) your money the primary concern must be "will I be repaid" and "will I be paid the returns offered"? These questions relate to the quality of the borrowers assets, skill in business and thus the profitability of the borrower. Don't spend too much time on title words.