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Macquarie looks for diversity with Commodity Bonds

Tuesday 1st of August 2006

8.2%pa, a global fund manager managing capital risk and a Standard & Poor’s credit ratingⁱ makes an attractive combination. But in the current environment of nervousness around the riskier end of the market in New Zealand, and with the lack of rated alternatives, Commodity Bondsⁱⁱ have quickly gained a lot of appeal with institutional and retail investors.

What are Commodity Bonds? Commodity Bonds offer a 5 year fixed income stream of at least 8.2%pa, paid quarterly. They are expected to be issued with a credit rating within Investment Grade that historically has related to a 99.5% probability of full capital and income payments being metⁱⁱⁱ.

But this strong yield and credit rating are not the main attraction for these investors. Its diversification - that is the big story for New Zealand investors, particularly those concerned about recent finance company defaults and stories of investors that were insufficiently diversified to avoid having major lifestyle impacts from these defaults.

Is diversification really that difficult? With all the choices available: capital notes; property trusts; investment property; finance debentures; Kiwi Bonds, its easy to diversify, isn’t it?

However, what if there was a shock to the New Zealand economy? While highly unlikely, imagine the effect of a shock to the economy that would be caused by, say for example, a foot and mouth breakout in New Zealand.

Such an outbreak would have consequences for every part of the economy, and therefore would impact all New Zealand fixed interest investments listed above. A portfolio spread across multiple New Zealand based investments may not be as diversified as it may appear at first glance.

The key questions to ask when designing a fixed income portfolio for your clients are: “What is it that provides the cashflow used to pay my interest costs on each of my investments?”; and “Are there any single event risks that could impact all of these cashflows at once?”.

Commodity Bonds derive their cashflow by taking commodity price risk on the principal, in much the same way that a dairy company’s capital notes pay interest in return for investors taking dairy price risk, or a retail company’s capital notes pay interest in return for investors taking risk on the level of retail spending. But these commodities are not linked to the New Zealand economy eg the price of Gold would not fall if there were a recession in New Zealand.

Some key points to note about Commodity Bonds and their link to commodity prices:

1. Commodity Bonds do not require prices to rise to be able to pay 8.2% pa
2. If prices fall to long-term averages^iv over the next five years, there is no impact on the return to Commodity Bond investors. That is why they are able to be rated Investment Grade by Standard & Poor’s – corporate issuers with the same credit rating experienced a 5 year default rate of around 0.5%, or 1 in 200ⁱⁱⁱ.
3. Having a manager is intended to assist in protecting against a loss of principal on the Commodity Bonds. The manager will have the ability to make changes to the underlying reference portfolio of commodities in order to attempt to preserve the principal at the end of the 5-year term.

Price falls below long-term averages^iv over a 10 day period near the end of the 5 year term may affect the return of principal as set out in section 3 of the Offer Document.

Profit from commodities even if prices don’t rise
Commodities and falls required before any potential impact on the principal of Commodity Bonds*. This illustration is based on the portfolio as at 10 July 2006. The only commodity from the energy sector currently included in the portfolio is Natural Gas.

* As at 10 July 2006 the Protection Amount protects the principal of the Commodity Bonds from the first 7 Portfolio Events. One subsequent event will reduce this principal to zero. A Portfolio Event occurs when the price of a commodity over a 10 day averaging period near the end of the 5 year term is below the relevant trigger level.
Current price – Commodity reference price as at 10 July 2006.
First trigger level – The highest trigger price for the relevant commodity in the Reference Portfolio.
Lowest inflation adjusted historic price – in 31 August 2011 constant USD terms, using monthly data from 31 January 1945 to 31 March 2006, assuming an inflation rate of 2.4% pa from 31 March 2006 to 31 August 2011.
Past performance of commodity prices is not necessarily indicative of their future performance.

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