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There is no free lunch
High yields have tradeoffs

Some finance firms are securitizing all kinds of things in an effort to offer higher yields to investors hungry for something more than the 4.5 percent boasted by top-paying GICs. Other debt obligations are coming to market offering higher yields with the appearance of safety - but there's always a catch.

Corporate debt and securitization

Bonds are generally backed or "secured" by the issuer's ability to pay. In the case of Government of Canada bonds, that's basically a guarantee since they can always raise taxes or cut spending in order to increase its cash flow to better service its debt.

Companies in the private sector, however, don't have this luxury and rely solely on their financial stability and cash flow generation to make good on periodic interest payments and the eventual principal repayment. In other words, most corporate debt - i.e. debentures - is unsecured.

A securitized bond or debt obligation is one that is backed both by the issuer's financial health and its pledge of specific assets. For instance, a manufacturing firm may issue bonds to build a new plant. In turn, it may simply pledge the to-be-built facility as security for buyers of the bond. If the firm fails to pay its scheduled interest, bondholders may eventually force the firm to sell the new facility to fund the principal repayment.

Securitized bonds are otherwise known as asset-backed securities (ABS) since there is some asset "behind" the bond to provide some security in the event of default. The pledged asset need not be physical in nature. Sometimes, it may simply be a right to some future cash amount.

Factoring

While some may remember this word from grade-nine math, it's also the name of an old corporate finance practice - factoring receivables. A key part of a firm's financial operations is its ability to collect promptly on its receivables - i.e. the amount owed to it by its customers.

Firms that have customers that don't like to pay on time and/or simply need cash will often sell away their rights to receive those eventual payments at a discount. For example, a financing firm may pay twenty cents for each dollar of some other company's receivables, if the seller is in desperate need of cash. On the high end, receivables may be purchased for up to fifty cents on the dollar.

The buyer then works to squeeze every penny possible out of its newly purchased asset - usually in the hope of collecting much more than what it paid. This practice is known as factoring receivables.

The dangling carrot

I recently reviewed a bond issued by private financing firm. Their one-page marketing piece sounded appealing. It boasted an 8 percent annual interest rate; roughly $1.5 of security for each $1 in bond principal; a portion of which was backed by government bonds; and a term of three years. Since three-year Government of Canada bonds offered yields of just 3.8 percent at the time, my "skeptic-radar" was off the charts.

Here's how they did it.

This firm was very active in factoring receivables. To use simplistic numbers, let's say they issued $1 in bonds. They'd typically take $0.20, for instance, and buy $1 of receivables (of which they expected to collect $0.70). They could then take the remaining $0.80 and invest it in government bonds. And presto - the firm could claim $1.50 ($0.70 + $0.80) in total assets in security for the $1 in bond proceeds raised. They could further claim that government guaranteed bonds secured more than half.

Key business risks could potentially impact both the interest payments and principal repayment.

The firm's ability to meet those 8% annual payments hinge on successfully collecting an adequate amount of receivables. That's the business risk. If they collect just $0.10 rather than the assumed $0.70, there are two consequences. First, interest payments may be missed. Second, collecting just $0.10 leaves just $0.90 in total security for each $1 in bond principal.

Further, this particular offering also charged an annual management fee (a percentage of total bond proceeds), provided bondholders received their full 8 percent interest in the year.

In short, the 8 percent interest was only as good as this company's operating efficiency. And if that was really poor, it could even jeopardize the security backing the bond.

While the firm may be good at doing its due diligence and might even be successful in its factoring activities, there is clearly a good deal of risk in the firm's operations.

The point of all this is that if it looks too good to be true, it probably is. A good starting point is to compare the yield on any type of bond or debenture with that of bonds issued by the Government of Canada for the same term. If the yield is significantly higher than that on government bonds, make sure you're fully informed of all applicable risks. Only then will you be able to make a smart investment decision.

See this previous article on questions to ask when considering new investments.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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