Complacency About Debt Comes Back To Bite
Sydney Morning Herald
Saturday January 19, 2008
Ouch. The doom fairies have certainly taken the gloss off Christmas cheer early this year. As if the banks showing unwanted initiative by lifting interest rates without a lead from the Reserve Bank wasn't enough, the markets have served a timely reminder that sharemarkets can generate hefty losses as well as profits.
By Thursday, the Australian market had fallen by more than 9 per cent since the end of last year and more than 16 per cent since the beginning of November. It makes the optimism that followed August's correction look decidedly rosy-hued.But what distinguishes this correction from many others - and particularly the tech wreck at the beginning of the decade - is that so many apparently conservative investors have taken a hiding. This correction wasn't caused by speculation in pie-in-the-sky companies. It was caused by loose lending practices and the packaging of debt into sexy investments that promised more than they could sustainably deliver. It's about how investors became complacent about the risks of debt in a benign economic environment and how that complacency is now coming back to bite. Forget the US subprime crisis for just a moment. Australia's wake-up call on the risks of debt first became apparent with the collapse of groups like Westpoint and Fincorp, which sold sophisticated debt offerings on a simple high-yield proposition. Back in early 2006 warnings were being sounded (in this column as well as others) about investments claiming to offer both high yields and safety. The concern was that investors did not fully understand the risks involved, nor was the extra return they were getting sufficient to justify those risks.In ideal conditions, these investments delivered as promised. But what we have seen in recent months is that when conditions deteriorate, disappointment is inevitable.While most retail investors were not exposed to the early casualties of the subprime fallout, the flow-on pain is starting to hit. Morningstar figures show many retail high-yield funds in the red over the past six months, with losses of up to 6.6 per cent. Some Australian bond funds are reporting losses, as are a number of enhanced cash funds - funds that are offered as an alternative to the mainstream cash management funds but with the potential for a higher return. While super funds will still report positive returns for 2007, those returns are back to single digits, with the researcher SuperRatings reporting that large balanced funds returned about 8.6 per cent after fees and taxes. That's respectable enough, but doesn't include this month's performance, which is likely to result in many funds going backwards.But perhaps the biggest shock to conservative investors is the listed property trust rout. While property is generally viewed as a growth investment with the potential to fall in value, LPTs have carved a niche over the past couple of decades as a safe, high-yielding investment. Retirees in particular have been encouraged to invest in LPTs as an alternative to accepting low interest rates, and have done very well from the sector.LPTs have been one of the best-performing sectors over recent years, delivering returns of 34 per cent in 2006 alone. But they have been hammered as confidence in the sector disappeared due to concerns about Centro. They ended last year down 8.4 per cent and have fallen 14 per cent so far this month.Now that the emperor has been exposed without his clothes, investors are focusing on negatives that have been building for some time. Specifically, that debt levels in LPTs have increased substantially in recent years as they have chased expansion, particularly in overseas markets, and that after several years of strong growth, LPTs had become, quite simply, overpriced.In the latter regard, LPTs are no different to any other investment and will inevitably represent good buying as prices fall. But as Select Asset Management's chief investment officer, Dominic McCormick, points out, for conservative investors chasing yield rather than capital growth, a 20 per cent fall in value can wipe out three or four years' worth of income. McCormick says the lesson isn't that you shouldn't have LPTs, but that risk is an essential part of the equation. He says risk levels are a factor of the price of the investment, as well as its inherent qualities. The credit crunch is also biting at the more aggressive end of the market. Rising margin loan rates and falling share prices have triggered margin calls and there is evidence of forced selling of geared investments. But more aggressive investors arguably understand the risks they are taking.Many conservative investors, on the other hand, have been enticed into investments where the risks were either disregarded or obscured by complex product structures. If, as seems likely, the markets continue to be volatile and further losses are incurred, we will inevitably see claims of mis-selling and other recriminations arising.But the market turmoil should also provide a timely reminder that rewards and risks are inevitably intertwined. Investors need to understand what could go wrong in both the short and longer term and to be sure it fits in with their objectives. And if an investment is so complex that these risks are obscured - or appear to have been financially engineered out of existence - it pays to be very wary indeed.
© 2008 Sydney Morning Herald