Wednesday, December 30, 2009

The right price for finance company investment

Some finance companies have recently announced that they will offer bond instrument investments without government guarantees in the near future. Some have added that these instruments will offer a return 1% higher than their equivalent with a guarantee.

David Chaston of the  rates blog wonders if this is “enough”… as he points out money that was going to the government would simply go to the investor (assuming the investment survives).

One clue as to what the pricing should be comes from the credit rating of the companies making the offer…. which is at present BB+ I use two data sources to price the spread for a given instrument issued by a company with a given rating – www.bondsonline.com – which provides a spread table showing spreads between US Treasuries and  corporate bonds of equivalent maturity with a given rating and a slightly modified database derived from Damodaran who draws from Bloomberg. I increase the spread slightly to allow for the virtually total absence of liquidity in N.Z. relative to mature markets.

From these sources we see that the premium ought to be between 2.58% and 4.25% with no government guarantee. If the government guarantee (which is capped and bound by some conditions – so is not a 100% safeguard) is worth 1% then the question is whether or not spreads between say 1.50% and 3.25% are sufficient to offset the risk of finance company instrument investing.

An interesting point is that the spreads do not change in a “straight line”.  Once companies reach investment grade (BBB) there is a significant reduction in the spread (as much as 2%) – at least as measured by these data sources. Put differently, falling below investment grade appears to carry a greater than linear rise in risk – and we should expect returns offered to acknowledge that.

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