The 7.25% subordinated note for a 72-year-old income client
Bruce, 72, has $300,000 from a maturing term deposit and wants 'at least 6% income with no sharemarket risk'. Your licensee's product list includes a five-year subordinated note issued by a NZ finance company, rated BBB- by an agency, coupon 7.25%, callable after two years, minimum $10,000. The note is not listed. The issuer's loan book is 70% commercial property and 20% construction. The note ranks behind senior debt and is not guaranteed by the parent. Bruce's only other income is NZ Super ($26,000 p.a.) and a $400,000 owner-occupied home. He has no emergency fund and a history of heart trouble. He says he 'does not understand duration' but likes the rate. He wants to invest the full $300,000.
1. Explain the key risks and how you would test suitability.
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The note is not a term deposit substitute. Its main risks are issuer credit risk, subordination, sector concentration, call risk, liquidity risk, and duration risk. BBB- is at the lower end of investment grade, and a loan book weighted to commercial property and construction is cyclical. If the issuer defaults, Bruce ranks behind senior creditors and may recover little. The issuer can call the note after two years if rates fall, forcing reinvestment at lower yields. With no listing, he may not be able to sell before maturity. Duration means the price would fall if market yields rise, although he intends to hold to maturity. Suitability testing should show that $300,000 is almost all his liquid capital, he has no emergency fund, and his health points to a need for liquidity. His income need is about $18,000 a year from the $300,000, which is only 6%; a lower-risk ladder can meet much of that. His stated lack of understanding of duration is a red flag. Investing the full amount would be unsuitable.
2. What alternatives and portfolio construction would you consider?
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Start with liquidity and diversification before yield. Hold roughly $30,000 to $50,000 in cash or short-term deposits as an emergency and health buffer. Ladder the rest across term deposits, senior NZ government or highly rated bonds, and a diversified income fund. If Bruce wants the subordinated note, cap it at perhaps 10% to 15% of the $300,000, spread across more than one issuer, and only with a written explanation of credit and call risk. Compare after-tax outcomes: $300,000 at 7.25% is $21,750 a year before tax, but a 20% credit loss would be $60,000, nearly three years of income. A lower-yield senior bond or deposit ladder produces less income but far less permanent-loss risk. If the note is held through a PIE, tax may be at his prescribed investor rate; if held directly, interest is taxed at his marginal rate. Tax should not drive the credit decision.
3. What disclosure and records are required?
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Disclose any commission, volume incentive, or other remuneration from the issuer, and any conflict arising from the product being on your licensee's list. Provide the product disclosure statement and explain the credit rating, subordination, call feature, lack of a market, and the issuer's sector concentration. Explain that the note is not guaranteed and that a credit rating is not a guarantee. Record his objectives, income need, risk tolerance, capacity for loss, health and liquidity constraints, the alternatives considered, and why you limited or rejected the full $300,000 allocation. If he insists on the full amount, record the advice against it and consider declining to implement. Keep records of the disclosure and the client's acceptance.