NZ Herald 24 October 2009

ALet’s not go back into why the couple, in their particular situation, would benefit from waiting three years before buying a house. We’ve already looked at that twice.

But I’m publishing your letter because I’m concerned about your confidence that houses in higher-priced suburbs won’t lose value in a downturn. That doesn’t sound right, so I asked an expert.

“There is no reliable data for suburb by suburb research on house price volatility,” says Song Shi, lecturer in property studies at Massey University in Palmerston North.

He adds that the volatility of house price movements can be caused by both fundamentals — supply and demand — and speculation. “In theory, speculation will increase the volatility of price movements over time. However, no evidence suggests that lower priced suburbs tend to be more or less speculative than higher priced suburbs.”

Anecdotally, richer neighbourhoods might actually be the wobblier ones. Several writers have observed that coastal property prices — which grew so fast in the middle of this decade — seem to have fallen further than other prices in the last couple of years. Could posher suburbs be similar?

Certainly that seemed to be the case in the property slump of the late 1980s. I know a couple who bought a house in the pricey suburb of St Heliers in early 1987. A year or two later they decided to buy a better house in a cheaper suburb.

Property prices had fallen, but they figured they would sell for less and buy for less, so it didn’t matter. They made the mistake of buying first, for about 10 per cent less than the house had been worth pre-crash. They then had to sell in St Heliers.

Lots of nosey neighbours came to the auction. But, while the auctioneer pretended to be accepting bids — a practice that was allowed in those days — nobody was really bidding. Some time later, the couple finally sold the property — a house that hadn’t deteriorated in a suburb that hadn’t deteriorated — for a full 30 per cent less than their purchase price.

I’m not saying that will happen again. But it could. There are no safe havens in property.

Anyone know of a worse story — of a house price that dropped more than 30 per cent? In what sort of neighbourhood?

AThat’s great that you’re happy with your adviser. But there are probably investments that would have been even better for you, but your adviser would have received no or low commission so you didn’t ever hear about them.

An adviser working on a commission basis is like a doctor who doesn’t consider all remedies or a lawyer who doesn’t consider every angle. They might do pretty well, but they can’t do as well as someone who looks at the full range of options and bases their selection solely on what’s best for the client.

More on advisers next week.

AThis is slightly tricky stuff. But it’s worth getting your head around it — whether you own preference shares with no maturity date or bonds that you may sell before their maturity date.

While bonds and preference shares are less risky than ordinary shares, if you unexpectedly have to sell them you can sometimes lose a fair bit — even though, as you point out, the issuer is not in financial trouble.

Preference shares typically pay interest — usually called a dividend — that is set at a margin above a specified market interest rate. These days, they often use the swap rate — the rate paid by a AAA-rated company on its bonds.

Periodically — often annually — the preference share dividends are re-set to a fixed amount above whatever the swap rate is on the re-set date. For Origin the margin is 1.5 per cent.

As you say, many interest rates — such as the rates on term deposits — have fallen in the last few years. But what’s relevant for preference shares is the interest on similar corporate bonds, as well as preference share margins above the swap rate, says Michael Chamberlain of SuperLife. And those have risen in many cases.

He says that a few years back, when Origin, Rabobank, ASB and others issued preference shares, there weren’t many bonds or preference shares available in the market. Therefore, people wanting income-producing investments were willing to buy the preference shares even though they didn’t pay a big margin above the swap rate. It was that or nothing — more or less.

Since then, more bonds have come onto the market — and we’ve gone through a financial crisis. With more competition and more uncertainty, a company issuing new bonds or preference shares has had to pay a higher margin above the swap rate or other benchmark to attract buyers. “The margins have become fairer, given the risk,” says Chamberlain.

This has made the older lower-margin preference shares unappealing. Why buy them, when you can get alternatives with similar risk that pay higher interest? Sellers of these preference shares have, therefore, had to accept low prices for them.

But that’s only part of the risk. Your happiness about the 8 per cent return is, unfortunately, short-lived. During the last week, the future dividend rate for Origin preferred shares has been re-set to 4.95 per cent — reflecting a big fall in the swap rate over the past year.

And I’m afraid there’s more bad news — about your Rabobank dividends — in the next Q&A.

Some day presumably you or your heirs will want your money back. Who knows where the market will be then — or for that matter, the creditworthiness of the issuer?

If all goes well, you might get back more than $1 per share. However, Chamberlain thinks market conditions were unusual when your preference shares were issued, and he doesn’t like your chances of getting even the par value — unless the issuer decides to redeem the shares because it no longer needs the money.

By comparison, most bonds are issued for a fixed period, often five years. At maturity, you get all your money back, regardless of what’s happened in the markets — unless the company is going under.

But if you sell a bond before maturity, you will be subject to the same market forces as preference shares. If interest rates have fallen, you’ll sell for more than you paid. But if interest rates have risen, you’ll have to take a loss.

AFirstly, I’d better explain to others how effective interest rates — called yields — rise as the preference share price falls.

The Rabobank preference shares were originally issued at $1, so if their dividend is 7.45 per cent that amounts to 7.45 cents per share. Someone who buys the preference shares for just 84.5 cents will still get that same dividend per share. And 7.45 cents on 84.5 cents amounts to 8.82 per cent.

That’s nice while it lasts. But Rabobank’s dividend has just fallen to an even lower level than Origin’s — reflecting that the Rabobank margin above the swap rate is just 0.76 percentage points. The new dividend is 4.12 per cent. At a price of 84.5 cents, that makes the yield a mere 4.88 per cent.

No wonder the price is well below the $1 par value. Potential buyers would have been watching the swap rate trend and seen the dividend fall coming.

Chamberlain reckons a “fair” margin above the swap rate for Rabobank preference shares is probably closer to 3 percentage points. “Because it is well below this, it will never approach $1 again unless it becomes common for all similar securities to have low margins again — or Rabobank chooses to repay the shares, which it can do.”

Add to this outlook the fact that if you want to get out, you have to pay transaction costs, and these preference shares don’t look attractive for anyone but traders who want to play the markets, hoping to get lucky.