Leverage and Self Managed Superannuation Funds

Posted on August 10, 2010
Filed Under Financial Regulation Discussion Paper Series, Funds Management & Superannuation, Policy | Leave a Comment

FRDP – 2010-03
August 9, 2010

The Cooper Review (1) did not make recommendations to limit use of leverage by SMSFs but recommended that recent proposals relaxing constraints on usage be reviewed in two years. There are several reasons which, on balance it is argued, support the view that SMSFs should not be able to leverage investments, and that policy should be changed accordingly.

Self Managed Superannuation Funds (SMSFs) have, for some years, been able to invest in levered products such as instalment warrants, despite a general legislative prohibition on borrowing by superannuation funds. Instalment warrants package together in a single financial product an investment in a listed stock with a no-recourse loan (of perhaps 50 per cent of the stock value) from the warrant provider. The warrant provider purchases the stock in trust for the investor, using the initial instalment contribution of the investor and the loan amount. Because the loan is no-recourse, the maximum loss to investors should they not make the required loan repayment (the “final” instalment) is the initial instalment amount. In that event, the warrant provider bears any loss due to the stock value being less than the final instalment amount, while otherwise the investor pays the final instalment and acquires ownership of the stock.

The attraction to investors of such products is the opportunity to leverage investments without risk to other wealth holdings (for which benefit a price is paid via the fees and interest paid to the warrant provider) and to exploit tax “arbitrage” opportunities. Some SMSFs have utilised investment structures which have enabled them to make instalment warrant type levered investments in property, by investing funds in a separate trust which purchases property using non-recourse loans. The Government’s March 2010 proposals(2) for changes to tax treatment of instalment warrants would effectively remove some anomalies in the tax legislation regarding treatment of ownership and taxation for such products and make use of such products simpler. The Cooper Review recommends that this issue should be reviewed in two years time and that providers of such products should be required to provide improved data on usage to enable better understanding of this market segment.

There are a number of arguments as to why use of instalment warrant products by SMSFs is not socially optimal and thus should not be permitted.

First, use of instalment warrants increases the risk being taken by the SMSF. While choice of a risk profile of investments is at the option of the SMSF trustees, it is not obvious that use of financial products which increase risk beyond some level is consistent with the policy objectives which justify concessional tax treatment of superannuation.

Second, because companies whose stocks are incorporated into instalment warrants borrow to finance their assets, those stocks are already levered investments on the underlying assets. Investment via an instalment warrant thus involves a doubling up of leverage.

Third, the tax deductibility of interest is permitted when a loan is taken out for investment in an asset which is expected to produce taxable income. One attraction of leverage, such as via instalment warrants, is the opportunity for “tax arbitrage” when some part of investment returns takes the form of capital gains which are subject to a lower tax rate(3). In the case of SMSFs, the investment is made to generate income which is already concessionally taxed (in addition to any advantageous treatment of capital gains in general). Whether tax deductibility of interest on loans taken out to generate concessionally taxed income is a socially appropriate or optimal policy is open to debate.

Fourth, one consequence of allowing SMSFs to invest in such products is to give incentives for financial services firms to create such products to market to SMSFs. And in general, complexity of product structure can become substantial. It is arguable whether trustees of SMSFs are able to adequately assess the risks and expected returns of such products, such that any tax benefits ultimately end up accruing to the providers of such products via excessive fee levels.

Fifth, it should be recognised that some proportion of the population will attempt to “rort” the system, while many others will be unable to understand its complexities. The former can be seen through attempts by SMSF trustees to structure property investments with a limited recourse loan from a third party – but where the trustee provides a personal guarantee to the lender. The latter is observable from the stream of requests to financial advisers about whether particular investment structures are feasible. Providing opportunities for leveraged investments contributes to both problems, and an optimal policy may be to simply ban such products rather than trying to police non-compliance with the requirements.

Finally, policy settings such as maximum contribution limits (and the now removed reasonable benefit limits) indicate a policy view that some upper limit on tax concessions provided through the superannuation system to individuals should apply. Allowing SMSFs to leverage up their concessionally taxed investments is at variance with that view.

This FRDP was prepared by Kevin Davis, Professor of Finance, University of Melbourne, and Research Director, Australian Centre for Financial Studies. kevin.davis@australiancentre.com.au

(1.) http://www.supersystemreview.gov.au/
(2.) http://www.treasury.gov.au/contentitem.asp?NavId=037&ContentID=1724
(3.) There is also a more subtle tax arbitrage effect arising from the inappropriate legislative treatment of some part of fees paid (which are essentially an option fee payment) as loan interest. See Christine Brown and Kevin Davis “Taxing Capital Protected Equity Products” Agenda, 12, 3, 2005, 239-252

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New database helps investors and researchers to better understand our share market

Posted on August 3, 2010
Filed Under Banking, Financial Institutions and Markets, Contracted Research and Consulting, Funds Management & Superannuation, Media Release, Research Review | Leave a Comment

Australian Centre for Financial Studies has partnered with ANZ Trustees to produce a newly digitalised database of Australian equities with a complete history of Australian listed company share prices and key financial ratios from 1966 to 1980.

Professor Deborah Ralston, Director of the Australian Centre for Financial Studies stated that “the Australian Equities Database (AED) fills a large data gap which has long frustrated academic and industry researchers. Drawing on original sources, it provides in one place comprehensive financial statistics across the local share market. It covers an important period of our economic history which we will do well to understand as we review long term investment benchmarks and target returns.  If people think recent times have been volatile, they shouuld take a look at the 1970’s.”

The AED has already then been used by ACFS to undertake a review of possible investment strategies using varying policy criteria. At the annual ANZ Private & Trustees Secular Review, the Australian Centre for Financial Studies released its long term Australian equities research to ANZ Executives. The Research was commissioned by ANZ Trustees to assist with identifying long term trends and market opportunities.

Ralston added that “once all historical data has been integrated with more recent series, AED will lend itself to becoming a vital long term portfolio modelling and trend analysis tool.”

The ANZ – ACFS research project linked industry and academic professionals, aligning well to ACFS specialities such as conducting leading-edge research, knowledge creation and transfer; all aimed at boosting Australia’s financial services industry’s global credentials.

The Australian Centre for Financial Studies facilitates industry-relevant and rigorous research and consulting, thought leadership and independent commentary. Drawing on expertise from academia, industry and government, the Centre promotes excellence in financial services. The Centre specialises in leading edge finance and investment research, aiming to boost the global credentials of Australia’s finance industry; bridging the gap between research and industry and supporting Australia and Melbourne as an international centre for finance practice, research and education.

The Centre provides access to and links between academics, finance practitioners and government and draws on expertise and experience from across these groups, to facilitate and disseminate knowledge creation and transfer throughout the greater finance community via its various activities.

The Australian Centre for Financial Studies (previously known as the Melbourne Centre for Financial Studies) is a not-for-profit consortium of Monash University, the University of Melbourne, RMIT University and Finsia having commenced in 2005 with seed funding from the Victorian Government.

Media contact details:
Professor Deborah Ralston
Director, Australian Centre for Financial Studies and
Professor of Finance, Monash University
W: +61 3 9666 1010
Mob: +61 0419 650 318
www.australiancentre.com.au

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Retirement planning is not just about super. Current projections show that the proportion of people receiving a pension will not change substantially by 2047 despite the growth in super

Posted on August 2, 2010
Filed Under Contracted Research and Consulting, Event News, Funds Management & Superannuation, Media Release | Leave a Comment

Australian Centre for Financial Studies (ACFS) is partnering with Finsia for a third year to conduct the Consumer Finance Symposium in Melbourne on Tuesday August 3rd. In 2010 it is themed “Financial Wellbeing in Retirement” and will highlight the many issues that individuals face in retirement and the challenge to Government of planning for an ageing population.

ACFS will conduct the afternoon workshop to encourage rigorous academic and industry research to understand how individuals make long term financial decisions and how they allow for their own ageing.

Speakers and topics at the ACFS workshop on Financial Decision-making:

• Dr Carsten Murawski, Senior Lecturer, University of Melbourne – Rational behaviours? What brain imaging may tell us about financial decision-making
• Professor Michael E. Drew, Griffith University and Managing Director, QIC Lifecycle Strategies – Target Date and Lifecycle Strategies – converting theory to practice
• David Williams, CEO, MyLongevity – Drivers of longevity, practical outcomes & available research data
• Rachel Lane, Executive Manager, Aged Care Solutions, Colonial First State Investments Limited – Aged Care: The struggle to provide Quality, Equity, Efficiency, Sustainability & Choice.

Professor Deborah Ralston, ACFS Director stated that “the responsibility for a happy healthy retirement rests with individuals and policy makers. Individuals need to recognise the need to save and there is a need for more products to address longevity risk. Women have some particular issues in this regard due to lower average incomes, and interrupted career patterns. At the same time women tend to live longer so need more svings. This presents a real challenge to policy makers and a demand for support mechanisms such as tax concessions, pension, health and aged care benefits.”

Ralston said ACFS supports recommendations of the Australian Super System Review (Cooper Review) to increase the efficiency of the superannuation system to enhance long-term sustainability. “While Australia enjoys a well rated retirement system by international standards, there is still much to be done in addressing the adequacy and sustainability of retirment incomes.” -END-

The Australian Centre for Financial Studies facilitates industry-relevant and rigorous research and consulting, thought leadership and independent commentary. Drawing on expertise from academia, industry and government, the Centre promotes excellence in financial services. The Centre specialises in leading edge finance and investment research, aiming to boost the global credentials of Australia’s finance industry; bridging the gap between research and industry and supporting Australia and Melbourne as an international centre for finance practice, research and education.

The Centre provides access to and links between academics, finance practitioners and government and draws on expertise and experience from across these groups, to facilitate and disseminate knowledge creation and transfer throughout the greater finance community via its various activities.

The Australian Centre for Financial Studies (previously known as the Melbourne Centre for Financial Studies) is a not-for-profit consortium of Monash University, the University of Melbourne, RMIT University and Finsia having commenced in 2005 with seed funding from the Victorian Government.

View event brochure

Media contact:
Professor Deborah Ralston
Director, Australian Centre for Financial Studies and
Professor of Finance, Monash University
W: +61 3 9666 1010
Mob: +61 0419 650 318
www.australiancentre.com.au

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Deregulating Retail Bond Issuance

Posted on August 2, 2010
Filed Under Banking, Financial Institutions and Markets, Financial Regulation Discussion Paper Series, Funds Management & Superannuation, Policy | Leave a Comment

FRDP – 2010-02
August 2, 2010

ASIC’s relaxation of information/disclosure requirements for retail bond issuance are warranted, but successful development of the retail bond market may require further steps to facilitate efficient issuance methods and investor demand.

The retail (and wholesale) market for corporate bonds in Australia has been largely non-existent, despite the growing volume of potential investors such as Self Managed Super Funds. Whether this has reflected inherent market economies of alternative corporate funding arrangements or regulatory impediments is open to debate, but relaxation of excessive regulatory constraints is to be welcomed.

Following responses to its December 2009 consultation paper CP126 , ASIC released Regulatory Guide 213 “Facilitating Debt Raising” in May 2010 setting out simpler issuance requirements for “vanilla” corporate bonds which are to be listed on the ASX and sold to retail investors.

“Vanilla” bonds are defined as unsubordinated bonds with a defined term of 10 years or less, paying interest at regular dates at either a fixed or a floating rate (at a fixed margin to a market indicator rate), with principal repaid at maturity. Issues must be for $50 million or more to achieve secondary market liquidity for investors. Required disclosures include key features of the bond (term, interest rate, payment dates etc), key financial information such as gearing, interest cover, working capital ratio, senior debt outstanding, plus information about the effects of the transaction on the company. Detailed corporate financial data is not required, provided that it is available via continuous disclosure requirements.

The issuance requirements introduce a simplified “vanilla bond” prospectus which can be used by listed companies which are eligible to issue a transaction-specific prospectus for new issues of listed (continuously quoted) equities. There is also provision for a two part prospectus approach in which a first-part prospectus with a life of two years can be issued, enabling the company to make a number of separate bond issues during that time each requiring a second-part prospectus detailing only the bond characteristics such as interest rate, term, etc. For these latter documents, relief is granted from the exposure requirement (usually that 14 days public exposure of the document is required before funds can be raised).

In effect, the rationale for these changes is that, other than transaction-related information, investors should not need more information to assess the investment risks of “vanilla” bonds than they do for shares. Since both are claims on the company’s assets and cash flows, albeit with different cash flow characteristics and control rights, this has considerable merit for which support can be found in finance theory.

An important distinction in practice, however, is that a market valuation of shares is already available, whereas there is no market valuation of yet-to-be-issued bonds. Most investors, who are unable to derive a fair bond price (yield) from first principles using share price data and company financial accounts, require some other source of valuation information. In particular they will want to know the appropriate credit spread (risk premium) for the issuer over government bond rates. Ratings agencies can provide comparative information if the bond issue is rated (although they may not always get the rating “right”), and investors have ready access to market determined yields on bonds of similar rating.

Regulatory Guide 213 is silent on the need for a rating, but the ASX listing rules for debt (Chapter 1, section 1.8) require a rating of at least investment grade. While this provides useful information, for most retail investors decisions to invest in new bond issues will be significantly influenced by issuing procedures and the advice and information associated with those processes. Regulatory Guide 123 is also largely silent on this issue, other than the requirement that “vanilla” bonds must be sold at a price common to all investors.

Standard bond issuance procedures operate much like those for an Initial Public Offering of shares, with the issuing company hiring the services of an investment bank to underwrite, market, and distribute the bonds to potential investors. This can be a relatively high cost exercise, particularly if retail investors are the target, and may inhibit development of the market. And the ability of investors to assess whether the issue price (yield) is “fair” remains questionable, raising issues of incentives of parties in the transaction. Dividing an issue into a wholesale component where a “bookbuild” through institutional investors generates an issue price which is then applied for the retail component is one way of addressing this issue. But there are others methods of price discovery and distribution potentially available.

Recognising that bonds, like equities, are ultimately claims on the company’s assets suggests that.issuance of “vanilla” bonds by way of a renounceable rights issue to shareholders might be a feasible approach. Any mispricing of bonds is then offset by equivalent gains or losses on the share price. Investors (such as institutions) not wishing to hold such securities could offer their rights on the exchange and price discovery would occur through the rights trading.

While issuance costs would be low, a pro rata bond-rights allocation may mean that significant trading of rights is required for small shareholders to build a suitable scale investment, while institutional shareholders not interested in such investments may be substantial sellers. An alternative may be to allow companies to make a (non pro rata) “placement” of renounceable bond-rights to a particular group of (or all) shareholders. Provided that the issue size was limited relative to market capitalization (as occurs for equity placements) and that the issue price was pitched at (or near) fair value, there is probably less risk of inter-shareholder value transfers than currently exists from the ability of companies to make placements of shares.

An alternative approach would be a placement of bonds to a financial institution which would then on-sell the securities to retail (or other) investors via the stock market (as currently occurs with listed warrant products created by investment banks), relying on financial advisers etc to alert investors to the availability and value of such securities. Whether this low cost issuance method would generate adequate price discovery and ensure fair pricing for retail investors is open to question.

But if a retail bond market is to be encouraged, it is likely to take more than changes to disclosure, and serious examination is warranted of whether alternative efficient issuance and distribution mechanisms are also inhibited by regulation.

(1) http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/cp126.pdf/$file/cp126.pdf
(2) http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/rg213.pdf/$file/rg213.pdf
(3) http://www.asx.com.au/ListingRules/chapters/Chapter01.pdf
(4) For example, arrangements for a recent AMP Note issue are described at http://media.corporate-ir.net/media_files/irol/21/219073/asx/3_11b.pdf (section 2.1.5).

This FRDP was prepared by Kevin Davis, Professor of Finance, University of Melbourne, and Research Director, Australian Centre for Financial Studies.
kevin.davis@australiancentre.com.au
Ph: 0409 970 559

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