Subordinated bond with non-cumulative coupons
Margaret, 68, has NZ$180,000 maturing from a term deposit next month. She needs about NZ$1,000 a month from her savings and has NZ$30,000 in a savings account. An adviser at a NZX participant firm is considering a NZX-listed subordinated bond issued by a finance company. It pays a 7.25% coupon, matures in seven years but is callable after three, and ranks behind deposits and senior debt. The issuer may defer coupons if its capital ratio falls below a trigger; deferrals are non-cumulative. On a further trigger event the bonds convert into equity. A five-year government bond yields 4.2% and a senior bank bond yields 5.6%. Margaret says the issuer is a bank, so the bond must be safe, and she wants the extra income. She has no other investments and a moderate risk questionnaire score. The adviser is deciding whether to recommend a NZ$90,000 allocation.
1. Identify the main product risks Margaret may not understand and explain how each affects her income objective.
Read the worked answer
The bond is not a deposit. Its main risks are:
- Subordination and credit risk: on default, Margaret ranks behind depositors and senior creditors, so recovery could be low even though the issuer is a bank.
- Non-cumulative deferral: if the capital trigger is breached, coupons can be missed and are not made up. A 7.25% headline coupon is not a guaranteed NZ$1,000 a month; a missed coupon directly breaks her income plan.
- Conversion trigger: a further trigger event converts the bonds to equity, which may be illiquid and volatile, and may pay no income.
- Call risk: the issuer can call after three years if refinancing is cheaper; she then faces reinvestment risk at lower rates.
- Liquidity and price risk: NZX debt can trade thinly; selling a NZ$90,000 parcel may need a discount.
- Interest-rate risk: price falls if yields rise.
The 7.25% coupon versus 5.6% senior bank paper and 4.2% government stock is compensation for these risks, not evidence of safety. The adviser should explain each in dollar terms: a missed coupon is NZ$6,525 a year on NZ$90,000, which is over half her target income.
2. How should the adviser test suitability and what should be documented if Margaret still wants to invest?
Read the worked answer
Suitability is not just the questionnaire score. The adviser should establish need and ability to take risk: her income requirement, the NZ$30,000 emergency fund, life expectancy, health, tax, and whether she could absorb a missed coupon or a 20% capital loss without changing her lifestyle. A moderate score is inconsistent with putting half her investable assets into a single subordinated security.
The adviser should model scenarios: no coupon for two years; conversion at a 40% loss; call at year three and reinvestment at 4%. Compare a smaller allocation, for example NZ$30,000 to NZ$45,000, alongside senior bonds, a diversified income fund, or a laddered term deposit. If Margaret insists on NZ$90,000, the adviser should distinguish an advised recommendation from an execution-only instruction. The firm may decline to recommend; if it accepts a client-directed order, it should record the client's reasons, the risks explained, the alternatives offered and the client's acknowledgement. File notes should be contemporaneous and in plain language. A suitability report should state why the product meets her objectives, or why the advice is limited.