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Market News – 18 February 2019

Thank you.

We regularly receive calls from new customers who tell us that a current client of Chris Lee & Partners has referred them to us.

There is no greater compliment than word of mouth recommendations, so, we wanted to say thank you to clients who have this level of confidence in our services that they are willing to recommend us to others.

We appreciate it and will always do so.

INVESTMENT OPINION

Bank Deposit Guarantees – If asked I’ll wager that the public would say ‘YES’ to any proposal for the introduction of bank deposit guarantees.

However, it’s not that simple and if pressed further into the debate I am equally certain that most of the public would recognise that you do not get something from nothing.

If a guarantee is added it represents a risk reduction for depositors through a transfer of risk to someone else and this has a real cost for the providers of the guarantee. Someone must pay for that cost and you won’t find it hard to conclude that depositors will pay for the service they are receiving.

For a depositor to ‘pay’ they will receive a lower interest rate, a logical response to carrying lower risk.

A deposit guarantee scheme is the provision of insurance. Do investors need this insurance?

I argue they do not.

Many investors can afford to self-insure against this risk, and they have access to well-regulated financial advice to further reduce their own risks of financial loss. It’s certainly easier to do this and to reduce costs than to find higher returns!

Paying for guarantees on bank term deposits would be wasted ‘money’ (returns) in my view.

I am far more inclined toward the central bank’s increasingly conservative regulation of banks, and the subsequent reduction of risk to you as an investor because this development brings with it other certainties for the NZ economy (broad financial stability and downward tension on the use of debt).

If a guarantee was initiated for a limited sum, say $100,000 per depositor per bank, the immediate reaction would be for depositors to spread money around various banks.

This resulting diversity for an investor seems logical, but if I was a banker I would view the situation as anti-competitive; ‘why can we not compete for you as a client on an undistorted playing field?’. We work hard to manage the best performing bank and we would like to compete for access to (say) $300,000 of your money as part of our business strategy.

The Reserve Bank clearly views complex subordinated bonds as distorting what is equity on a bank’s balance sheet and providing an unintended competitive advantage to the major banks over the smaller banks. So, surely the RBNZ would also see a deposit guarantee scheme as an unnecessary distortion too, probably in favour of the smaller banks.

You can tell that I am not a fan of a bank deposit guarantee scheme.

I was taken to write this piece for you after reading two good opinions on the subject in response to Treasury seeking feedback on the subject, and because all of our clients have bank term deposits.

One opinion was written by Dr Bryce Wilkinson (another of the long list of excellent people I have worked with) who was happy for me to re-present the link to his item:

http://www.nzinitiative.org.nz/reports-and-media/opinion/the-case-against-taxpayer-guarantees-for-bank-deposits/

For the sake of balance, Bryce suggested that I also point you to an opposing view from Geoff Mortlock, here:

https://www.interest.co.nz/opinion/97926/geof-mortlock-argues-new-zealand-needs-stronger-protection-depositors-counter-reserve

There is no action for you to take, but I’d encourage you to read these two opinions because you’ll always have money in bank deposits, so the subject is perpetually relevant to you.

Speaking of perpetually, and banks…

ASB Repayment – We continue to be energised for our clients following the announcement that the ASB perpetual peference shares (ASBPA and ASBPB) will be ‘repaid’.

Holders of ASB perpetual preference shares have received a notice from the bank (technically issued by CBA Funding) announcing repayment. Our clients also received an email from Kevin Gloag to ensure they had observed the good news.

The letter from the bank was well written. It speaks to the legal detail of the ‘buy-out’ notice and the ‘transfer’ of securities, but it also makes clear that holders of the perpetual preference shares do not need to take any action. You will all be ‘repaid’ (technically you will be paid for the sale) on 15 May.

The repayment is very exciting news as its rewards investors for the confidence they placed in the financial advice to buy these securities while the pricing was discounted in the face of declining interest rates for annual reset securities.

Everyone’s financial returns will differ based on entry prices and time frames, but if you’ll allow me to discuss a rough performance range:

If an investor purchased the securities at 85 cents in the dollar (a credible point through the middle of trading for the past 10 years);

The investor(s) received dividend rewards of between 3.50% - 6.50% over the years (slowly declining); plus

They will now receive a value uplift of 15 cents in the dollar (for this calculation).

With simplistic math you can divide this 15 cents uplift by the years of ownership to see that investors will gain an additional 2-15% annual return making it an impressive overall return for investors who purchased securities at a price discount.

This is an impressive overall return regardless of your specific time frame.

I have made no attempt to address differing tax implications, I just wish to illustrate the high overall reward delivered by this investment to many people when they combine annual income with the value uplift on repayment. These investors did not need an increase to New Zealand’s interest rates to secure the attractive reward.

By the way, Kevin Gloag is too humble (and maybe short of breath – Ed) to blow his own trumpet on this subject of investment in subordinated bank bonds (various securities types) but a huge proportion of the high rewards that our clients have enjoyed from this sector is directly linked the deep knowledge that he gained about bank equity and regulatory capital risks.

We took this deep knowledge to measure the low default risk and relatively high return and presented it to clients in the form of financial advice and for the content of our country-wide roadshows a few years ago to keep investors abreast of important changes to bank regulations which were introduced in 2013.

To be fair to Kevin nobody here blows a trumpet, it would sound awful, but when I reflect on the value that our clients have received from many years of participation in the subordinated bank bond market, I am very pleased about the high returns they have received.

Long-time clients will recall investing in what I’ll call ‘generation one’ bank capital securities such as BISHA, BNSPA, RBOHA, RCSHA, ANBHA (CASHA! – Ed).

Our view at the time was that the banks were operating at the edge of regulatory tolerance using these securities as ‘equity’ on their balance sheets, that they would all meet their financial obligations for these securities and thus the rewards to investors were attractive for the risk involved.

Our view was validated when the central banks tightened capital regulations and effectively enforced the repayment of the generation one securities on the next available date (Interestingly Rabobank’s RCSHA haven’t reached that date yet, being June 2019, and investors will be sad to see this one repaid).

It’s fair to say we were relieved, rather than unsurprised, when Credit Agricole repaid CASHA. We had less knowledge and less confidence in the European regulators and the French banks!

The central banks then set tougher rules for when a ‘bond’ could be viewed as ‘equity’ on a bank balance sheet.

The banks promptly started issuing ‘generation two’ of bank capital securities such as ANBHB, KCFHA. One or two banks spotted the unhappy regulatory tone and stopped issuing such securities for raising equity.

All the while ASB Bank left its perpetual preference shares on issue, now 15 years of age (2002 and 2004 issuance).

Oddly the Reserve Bank of NZ singled out Kiwibank for criticism early with its generation two subordinated bonds.

Again, the central bank in NZ declared that they were dissatisfied with the use of ‘bonds’ as ‘equity’ and have now announced proposals to only count ordinary shareholder funds plus retained earnings as equity. Their latest proposal is very robust in its target equity ratios, but the definition of true equity is as it always should have been.

Regardless of the unsettled proposals from the RBNZ it is highly likely that ANZ and Kiwibank will repay their generation two subordinated bonds that have counted as Tier 1 bank equity.

The latest RBNZ development on bank capital and the highly critical report on poor customer service from the Kenneth Haynes banking review in Australia are probably the drivers behind CBA and ASB repaying their NZ perpetual preference shares.

Regardless of the drivers we repeat our compliment from last week about the bank’s decision to repay these securities. To leave these securities on issue as a cheap loan that had morphed from equity accounting would have been a deeply inappropriate stance to take in capital markets, especially one as small as New Zealand.

Now this high yield game appears to be up. Investing in complex bank securities for high interest rate rewards and very modest risks will no longer be an option.

The 10-year ride made for a much longer wave than we could have expected for you when it began.

I’m not sure where you’ll put all the ASB millions that are being returned (then ANZ and Kiwibank in 2020), but that doesn’t change our satisfaction from watching these repayments occur.

You’ll have seen our developing comments that we are supportive of the newly proposed regulations for bank capital and Kevin has, as usual been getting his head into how they’ll work and the impacts they are likely to have on our clients.

Kevin plans to write Market News for you next week in our latest effort to keep you up to date with the evolution of bank capital and its impact on the investment options they present to you.

INVESTMENT NEWS

RBNZ – The Reserve Bank of NZ released its latest Monetary Policy Statement last week and for reasons that I wasn’t abreast of they changed the day and time.

An MPS is always a little dry but it is also highly valuable information for investors to consider and it’s nice to have Adrian Orr’s style to make the content a little more readable.

Here’s the link to the full statement on the RBNZ website for the curious:

https://www.rbnz.govt.nz/-/media/ReserveBank/Files/Publications/Monetary%20policy%20statements/2019/mpsfeb19.pdf

The status is unsurprising, being ongoing very low interest rates, often with negative real returns.

This interest rate environment is making it very hard for investors to consider the sale of any other asset type, regardless of market valuations or impending regulatory changes.

CEN – Contact Energy is displaying the success of its strategy to slim-down and focus on electricity generation and retailing (they have been selling their gas industry businesses) and a reduced capital spending programme, witnessed by reduced debt profile and wider earnings margins.

They have reached the point of increasing their dividend payments to 100% of free cash flow which resulted in an increase from 32 cents per share to 39 cents per share.

This may mean that the gradual rise in their share price slows as investors perceive there to be less savings, or wider margins, to be achieved in the years ahead but ultimately, we invest for recurring profits and dividend payments so this dividend increase will appeal to all shareholders and is a robust display of financial success for the business.

Most investors hold shares in the electricity generation sector, predominantly as a result of the share floats arranged by the government so I suspect their observations will lead them to realise that whilst the core product is the same for most, they all go about it with slightly different strategies from different geographic locations.

Ultimately this means, to me, that there is no ‘best’ generator/retailer of electricity and like a lot of investing claiming a diverse selection across the sector makes good sense.

Further, owning a few shares in the sector has proved to be a good hedge (protection) against the rising price of electricity as a consumer and I suspect this balance will be perpetually true.

Trustpower – TPW’s latest statement alerts me to the fact that my electricity prices may not rise in the year ahead.

There are always two sides to market pricing expectations.

TPW directors intend to revalue the assets on its balance based on expectations of lower electricity pricing in the future.

They do not expect a significant impact on underlying profits and have been paying special dividends as a result of their robust financial position.

They will use the money raised from last week’s bond issue to reduce bank debt, which is a nod to the fact that bond funding now offers two benefits; cheaper pricing and longer duration funding.

Investors should re-read that last sentence.

Fletcher Building – We look forward to reading FBU’s first half result on Wednesday, the first full half year for ‘new’ CEO Ross Taylor (great batting average – Ed).

The Formica sale, debt reduction that affords and new strategic focus implies that FBU will return to paying dividends.

I once said that it will take Ross Taylor two years to prove to investors that his new strategy will be effective. He is six months along that path so let’s give him more time yet before throwing too many headlines around.

Insurance – I know, not our space, but I do wonder if any of the insurance companies are troubled by reporting the strong increases in profit at the time our regulators are so unimpressed by their service levels?

We know they pounce of each unique risk event to explain their ‘need’ for increased pricing without doing any math for us on the present value of permanently increased pricing alongside temporary risk events.

EVER THE OPTMIST – I really like that Kiwi Rail’s chairman, Greg Miller, is talking in terms of 10 to 20 year plans.

Last week he spoke to a government working party about the potential for a new, modern, large dry dock to support our larger ships and preference to operate more coastal shipping for trade.

He carefully didn’t describe pricing or location but Wellington or the Marlborough Sounds are nicely central and protected from prevailing weather patterns.

I’d love to see Wellington make productive use of that large lump of land right beside the current Interislander terminals. If not a dry dock, then maybe level it as a camper van site with direct access to the ferry and water taxi pick up to take them to town.

INVESTMENT OPPORTUNITIES

Trustpower – Confirmed the issue of its new 10-year bond last Friday, setting an interest rate of 3.97% for the period until 2024.

Thank you to those who participated in this bond offer through Chris Lee & Partners.

If you missed the issue and still wish to invest, please contact us urgently as we have a modest amount of the bonds still available for clients.

Contact Energy – has announced that it is ‘considering’ an issue of a new 5-year senior bond. Details will be announced next week but we offer the following as a head start:

CEN has a BBB credit rating and the bond will mature on 15 August 2024.

We estimate that the interest rate will fall in the range of 3.30% - 3.50% (underlying interest rates have increased a little).

We expect this to be a fast-moving bond offer, confirmed by contract note (no application form) and investors being charged brokerage.

We have a list for those who wish to invest in this bond offer. Please contact us promptly (coming days) if you wish to invest once this offer is formalised).

Napier Port – The regional council has approved the sale of some shares in the port and now appointed its lead managers to bring the offer to market (in the months ahead).

This is an exciting development for investors, and the NZX, and we look forward to this Initial Public Offer reaching the market.

We have a contact list for investors wishing to hear more about participation in the float of Napier Port.

TRAVEL

Edward will be in Napier on 25 February and in Auckland (Remuera) on 8 March.

David will be in Kerikeri on 4 March, Lower Hutt on 20 March.

Chris will be in Auckland on February 25 and 26.

Kevin will be in Christchurch on 7 March.

Mike Warrington

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