Part 3 of 3 of a Treasury Staff Insights: Rangitaki article by Juston Anderson
In my previous article on Air New Zealand, I mentioned the concept of risk as being important when considering returns. Risk is also relevant to the discussion about the dividends from the electricity companies. In this final part of this series of articles, I want to illustrate that with a real world example.
Meridian Energy’s bond issue
On 1 March this year, Meridian Energy announced a $100 million bond issue, with provision to accept oversubscriptions of up to $50 million. Investors could apply for a minimum of $5,000 of the bonds, and in multiples of $1,000 after that. On 7 March Meridian Energy confirmed that the interest rate on the bonds was 4.53%.
People who were considering investing in those bonds had wide range of alternative investments, but I’m just going to look at one of those: shares in Meridian Energy.
On 7 March, Meridian Energy shares were trading on the NZX at $2.57. In the twelve months before then, Meridian Energy had paid a total of 18.23 cents per share in dividends. If Meridian Energy was to pay the same amount in dividends over the next twelve months, then someone who bought Meridian Energy shares on 7 March at $2.57 might receive a dividend yield of 7.1%.
Meridian Energy’s dividends also generally have imputation credits attached to them, although they are not always fully imputed. Any imputation credits attached to dividends could, depending on the investor’s circumstances, reduce their tax bill. Effectively, the dividend yield becomes at least partly tax-paid (based on the imputation credits) while the interest earned by an investor who owns Meridian Energy bonds will be taxable.
So given the choice of investing in Meridian Energy by buying some of its shares and possibly receiving a return of 7.1% (partly tax-paid), or investing in Meridian Energy by loaning it some money (purchasing some of its bonds) and receiving 4.53%, less tax, why would anyone buy the bond?
In fact the bond issue was successful, with Meridian announcing on 7 March that “following strong investor demand ... it has set the [bond] issue size at $150 million, accepting oversubscriptions of $50 million”.
Why is this? Well the fact that I said a possible return of 7.1% from Meridian Energy shares is a good clue.
Dividends from Meridian Energy are not fixed. Meridian Energy does not say how much it will pay in dividends over the next twelve months, and nor is there any guarantee it will pay any dividend at all.
I calculated the theoretical 7.1% return based on the dividends Meridian Energy paid last year. But next year’s dividends could be lower, or higher, and it’s possible no dividend could be paid at all.
One important difference between bonds and shares is that an investor in Meridian Energy’s bond issue has a high degree of certainty they will receive a 4.53% interest payment, while an investor in Meridian Energy shares has much less certainty about the dividends they will receive.
Another important difference is that Meridian Energy’s bonds mature on 14 March 2023; at that point, holders of the bonds will be repaid the initial investment. Shares don’t mature, and although they can be sold, there is no certainty around what the price will be.
Meridian Energy’s bonds are also tradable, if an investor doesn’t want to hold them until they mature in 2023. Like Meridian Energy shares, the price of the bonds will go up and down, but generally the prices for listed bonds are less variable than share prices.
The fact that there is greater uncertainty for investing in shares means an investor will want to receive some compensation for accepting that uncertainty. This is one of the reasons why interest rates on investments like bonds are usually lower than dividend yields on shares.
That doesn’t mean bonds are a “worse” investment than shares. Some investors will prefer the certainty of interest from bonds, and the greater certainty that comes with a fixed maturity date; others will prefer to invest in shares, where there’s less certainty around the income they will get from dividends, but potential upside from movements in the share price (and potential downside as well).
How is this relevant for the Crown?
Uncertainty around commercial returns is just as much of a factor for the Crown as it is for any investor.
In parts 1 and 2 I showed that by listing the electricity companies on the sharemarket, and selling 49% of their shares, the Government has actually participated in an increase in their dividends (although some of this increase probably would have happened anyway) but also, it has reduced uncertainty. This is from swapping uncertain commercial dividends for much more certain reductions in debt servicing costs. It’s also from the more stable dividends that should be paid by the electricity companies now that they are listed (based on what we have seen them pay so far, and on what Contact Energy and Trustpower have paid).
Greater certainty (lower risk) is worth something to private investors, as shown by the fact that they were willing to invest $150 million in Meridian Energy bonds. It is also valuable for the Crown.
-  Obviously there are several other differences between bonds and shares
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Treasury Staff Insights: Rangitaki
See Treasury Staff Insights: Rangitaki for other articles in this series.