Unrated Woolworths notes lack institutional appeal

Woolworths launched an offer for subordinated, and ASX-listed, debt last week. Aimed largely at retail investors, the notes will pay a margin of between 3.25 per cent and 3.50 per cent over the 90-day bank bill rate.

Superficially, this is an appealing yield, though priced at a level below the comparable debt of banks (as Woolworths, historically, has been able to do).

A survey of the history of Woolworths' use of public debt issues (rather than borrowing from banks) may help put this offer in context.

The issue follows on from an earlier issue of retail debt, known as Notes I, which Woolworths redeemed last month. That issue, undertaken in 2006, had, in turn, replaced the Woolworths Income Notes dating from seven years earlier.

The Woolworths Income Notes issued what were known as perpetual income notes in late 1999. There was a rash of similar securities issued around that time that prompted the first issue of such securities by National Australia Bank.

However, the appeal of "income securities" issued by a number of borrowers in 1999 quickly waned as investors realised that perpetual means perpetual. One or two also ran into tax strife. Those that remain (from NAB and three other banks) trade at quite a discount to face value, along with their coupons being well below current market expectations.    

On this occasion, Woolworths is seeking to raise a minimum of $500 million from the sale of Notes II. The minimum investment is $5000 and the size of the investment can be increased in increments of $1000.

The exact margin on Notes II (of between 3.25 per cent and 3.50 per cent) will be determined in the book build tomorrow.  This means the yield will be around eight per cent, assuming the price is set at the low end of this range, which seems likely.

The coupon payments are deferrable but cumulative. Any deferred coupon payments must be paid within five years from the date of the first deferral.

If coupons are deferred, Woolworths is prohibited from paying a dividend to its shareholders until the coupon payments are made.

The Woolworths Notes II are not perpetual but do have a 25-year term to maturity. However, Woolworths has the option to redeem the notes after five years or upon every coupon payment thereafter.

Woolworths has some incentives to redeem the notes after five years. There is a coupon step up of 1.0 percentage points that applies if the notes are not redeemed at that time.  And Woolworths will lose the equity credit granted for the notes by rating agency Standard & Poor's at that time.

Note that there is no formal rating on this subordinated debt, since the debt is pitched at the retail market and credit ratings agencies lack the appropriate licences. The Standard & Poor's rating on Woolworths' senior debt is A-.

The views of S&P on Woolworths' credit rating do matter, since the rating agency will allow an "equity credit" (that is, pretend that the debt is equity) for 50 per cent of the value of these notes when it comes to calculating Woolworths' gearing and debt-service ratios. This will effectively allow Woolworths to have a higher senior debt credit-rating than might otherwise be the case.

A higher senior debt credit-rating should allow Woolworths to raise cheaper senior debt. And this is the reason why Woolworths wishes to issue the subordinated Notes II.

However, this equity credit will only be allowed for the first five years of the life of the notes. S&P does not allow any equity credit for debt instruments with a term to maturity of less than 20 years.

This provides another incentive for Woolworths to redeem the Notes II after five years.

Also, Woolworths has entered into a replacement capital deed with S&P which requires the Notes II be replaced with similar subordinated notes or equity upon redemption.

Investors don't really need to worry about these technical aspects, but they do need to understand that their position is subordinate to all other creditors and senior debt-holders. In the event of Woolworths being wound up, Notes II-holders will rank just ahead of shareholders.

With this in mind, it is important investors have an understanding of the credit quality of Woolworths, so a view can be formed as to the likelihood of Woolworths defaulting on its obligations and being wound up.

Unfortunately, as mentioned, the Woolworths Notes II will not be rated.

There is an unfortunate trend emerging of listed debt securities being unrated, thus denying retail investors an independent assessment of the credit risk of the issuer. This is the result of there being mostly two types of issuers of debt securities.

The first type of issuer is a company like Woolworths. It has an investment-grade credit rating for wholesale debt issuance, it is well known to retail investors, and it doesn't want to pay for another credit rating.

The second type of issuer, of which there are many (such as finance companies"), is of poor credit quality and these issuers' managers don't want retail investors to know this.

This second type of company is hoping its credit risk will be under-estimated and, thus, it will, effectively, be able to obtain cheap debt to the detriment of its retail investors.

Australian Unity, with a 'BBB+' rating from Australia Ratings, is an exception to these two types of issuers.

One disadvantage for Woolworths in not having its Notes II rated is that the absence of a credit rating will limit the participation of institutional investors in the issue.

Woolworths is, notionally, targeting institutional investors, just as it did with the 2006 issue of Notes I and the 1999 issue of perpetual income notes, but these issues were rated. Many institutional investors are prevented by their investment mandates from buying unrated debt securities.

Many institutional investors will not think much of the spread over bank bills either. Subordinated debt of Bank of Queensland, for example, pays 350 basis points over bank bills, and the corresponding debt of Axa pays 600 basis points over bank bills.

The offer for Notes II will open on Wednesday and will close on November 17 for Woolworths' shareholders and the general public. Trading on the ASX will start, on a deferred settlement basis, on November 25, with normal trading beginning on November 30.