Income Investor: Tabcorp Bonds Review (2/4/2009)

incomeinvestor review, 2/04/2009

Company: Tabcorp Bonds (TAHHA)
Recommendation: Avoid
Price at Review: $100.00
Fundamental risk: 2
Share price risk: 2
Category: INCOME SECURITY
We’re excited about a potential flood of corporate bond issues in the coming months. But buying the first of these retail offers is unlikely to be your best option.

A bond is best thought of as a loan, but a loan that comes in the form of a debt instrument that can be freely traded, rather than one where the lender is locked in for the term of the loan. Bond issuers include federal and state governments (government bonds) and a wide range of large companies (corporate bonds).

Today, most bonds trade in an institutional, or wholesale, market. Here, sophisticated buyers (lenders) deal with sophisticated sellers (borrowers) in an unlisted market. There are limited rules regarding disclosure and, until recently at least, it was easy for both companies and governments to raise vast quantities of money with minimal hassle.

In the more distant past, there was also a retail bond market where folks like us could also buy and sell more modestly sized parcels of bonds. But this market was strangled, partly the result of disclosure rules designed to protect small investors, as borrowers opted for the relative ease and lower costs of the wholesale market. There hasn’t been much action in retail bonds since the federal government started running a budget surplus in the 1990s.

Retail back in vogue

But, as a result of the global financial crisis, the wholesale corporate bond market has ground to a halt. Non-financial companies haven’t issued any new bonds since late 2007, and this easy source of funding has dried up. Understandably, then, companies are again eyeing retail punters, and the ASX has seized the opportunity to streamline the listing process so that these bonds can be traded on the stock exchange. Being listed is an attribute highly valued by retail investors.

So we expect to see a flood of new stockmarket-listed bonds targeting retail investors over the coming months. AMP was the first to hit up the retail market, and the latest offer comes from gambling giant Tabcorp. It’s a five-year floating rate bond that pays interest quarterly based on the 3-month bank bill rate plus a margin of 4.25%.

A floating rate provides protection against rising interest rates. If at the start of a quarterly period, the 3-month bank bill rate is 3.1% (approximately where it sits today), then at the end of that quarter you’ll receive interest based on an annual rate of 7.35% (3.1% + 4.25%). And if in 2012 the 3-month bank bill rate has risen to, say, 7.0% as the Reserve Bank attempts to halt rampant inflation, then that quarterly payment will be based on an annual rate of 11.25%.

While the prospectus weighs in at about 100 pages, this offer is simpler and much fairer than the income securities and hybrids issued between 2003 and 2007. While Tabcorp bonds are unsecured, they are also unsubordinated which means that, in the event of default, bond owners are considered equal to other unsecured debt holders in their claim on the company’s assets.

Unavoidable interest obligations

And when it comes to the payment of interest, you won’t find words like ‘discretionary’ or ‘non-cumulative’ in the prospectus. Point 5.1 (a) on page 77 spells out clearly that if any money owed to bondholders isn’t paid within three business days of it falling due, then the company is in default and the trustee is able to start proceedings to force Tabcorp to sell assets to meet its obligations.

Important details

Issue price: $100.00

Bonds on issue: 2m-plus

Interest rate: 3-month bank bill rate plus 4.25%

Current 3-month bank bill rate: 3.10%

Closing date: 24 April 2009

Listing date: 4 May 2009

Maturity date:1 May 2014

When the bonds mature on 1 May 2014, repayment is in cash only, again differentiating it from many hybrid issues repayable with shares. This is a far superior structure compared with the recently floated Westpac Stapled Preference Security II, which incidentally offered a slightly lower margin of 3.8% over the 3-month bank bill rate.

But ultimately, the decision on whether to invest revolves around whether a margin of 4.25% is tempting enough to lend to Tabcorp. For us, it’s not quite enough. The three main operations of the company face differing threats. The economics of the casino business are, we suspect, tougher than most investors realise. The refurbishment of Star City Casino in Sydney is going to cost about $500m over the next two years. Wagering faces a huge online threat and the main part of Tabcorp’s gaming business, its Victorian gaming licence, will cease to exist after 2012. Given Tabcorp has some $2.2bn of other debts, it’s not an entity we’re in a rush to lend to. While 4.25% over the bank bill rate is vastly better than what was offered a few years ago, we don’t find it compelling.

Companies are coveting our cash right now because they cannot get it elsewhere, and we must be careful to avoid being their patsy. Given the huge amount of debt that companies are looking to refinance outside of the banking system, we suspect they’ll keep issuing bonds until retail investors have had their fill.

Patience is likely to pay in this environment. We intend to look at each new issue but are likely to say ‘no’ to most of them, preferring to wait and cherry pick the best opportunities after they list on the market. The upcoming flood of new corporate bond issues is great news, but more for the opportunities they might create down the track.

There are a few other subtleties to the Tabcorp offer, including a first-year bonus interest payment of 0.25% for those who buy in the float and hold for 12 months. But they don’t change the equation substantially. We don’t intend to cover the Tabcorp bonds on an ongoing basis, but might look again if they trade at a meaningful discount. Our view on the float is AVOID.