In the aftermath of the 2008/09 Global Financial Crisis (GFC), many astute investors shifted their focus away from conventional managed funds (unit trusts) and turned towards direct equities and Listed Investment Companies (LICs).
This shift in investment preference was driven by a sound rationale. Numerous fund managers were exposed as mere index replicators*, lacking the acumen of true stock pickers. The negative performance further compounded the issue by leading to a halt in distributions. For investors and Self-Managed Superannuation Funds (SMSFs) relying on consistent and dependable income streams, this lack of certainty posed an unacceptable risk to income planning and overall lifestyle.
Essentially, a LIC is a unit trust that has been enveloped within a corporate structure and listed on the Australian Securities Exchange (ASX). The beauty of this structure lies in its ability to retain profits and, as long as it remains solvent with sufficient retained earnings, declare dividends of any amount at any time. Consequently, even during a year of negative returns, a LIC can still distribute dividends while passing on any franking credits to shareholders.
Yield Enhancement through LIC Share Price Discount
Criticism has been directed at LICs, pointing out that their share prices tend to trail behind their Net Tangible Asset (NTA) value—and this criticism holds some merit. Nevertheless, many investors purchased these stocks precisely because of the discount they presented, and they stand to benefit from the subsequent narrowing of this discount over time. Flagship Investments Ltd is dedicated to maximizing returns for shareholders through proactive measures aimed at reducing any such gaps.
Surprisingly, investors may be unaware that dividends are declared on a per-share basis in many LICs. LIC boards often maintain a steady dividend, typically around 4% to 5% per annum of the portfolio’s value (NTA). Under this arrangement, if the share price is discounted compared to the NTA, the dividend effectively translates into a higher yield.
Consider the following example: Suppose the NTA per share for a company is $1.50, while the Share Price stands at $1.20—a 20% discount to the NTA. If a 5% dividend is declared, it would amount to a dividend of 7.5 cents per share. Thus, the dividend yield would actually be 6.25%.
LIC Capital Gains Discount
Dividends from LICs can include an attributable capital gain component, offering additional benefits to specific shareholders. In cases where a LIC has paid taxes on capital gains from investments held for over 12 months, these gains can be “attached” to the dividend, allowing shareholders to apply capital gains discount methodologies, such as the 50% discount on gains for individuals.
The LIC Dividend Reinvestment Plan: Adding Value
Numerous LICs provide a Dividend Reinvestment Plan (DRP), enabling shareholders to convert their dividends into shares, often at a discount to either the NTA or Share Price. For shareholders, the compounding effect of reinvested capital can have a positive impact on their portfolios over time, while the LIC can utilize the reinvested funds in its investment portfolio.
Why Do LICs Issue Convertible Notes?
LICs issue Convertible Notes when their managers hold a positive market outlook and wish to invest additional capital. When the Board endorses the investment manager’s judgment, it must determine the most suitable means of providing the necessary capital.
A fund manager consistently outperforming the market over the long term deserves ample funds to invest in it. Similar to the DRP example, a LIC that retains more capital within its portfolio actively works to benefit both shareholders and the company.
Two Ways for LIC Boards to Raise Capital
LICs can raise new equity through methods such as share placements, rights issues, or share purchase plans. However, if the offer price falls below the NTA, issuing new equity would not benefit shareholders, as it would dilute the returns for those who did not participate in the new equity issue. Flagship Investments has a policy of avoiding unreasonable dilution of shareholders’ holdings.
Alternatively, a company can issue debt in the form of Convertible Notes. This method does not dilute the NTA and is a well-regarded means of raising capital within a LIC.
Desirability of Convertible Notes for Income-Seeking Investors
The market for income-bearing investments, including hybrids and Convertible Notes, has gained popularity. This exposure to income-oriented investments opens up a broader audience of potential shareholders for LICs. From an investor’s perspective, Convertible Notes provide a steady income stream through fixed-interest coupons, but they are not without risks. Although the company may back them, their value can become negligible if the company goes out of business. The key consideration lies in the company’s ability to fully repay the Notes at the end of their term.
Incredible Safety of Convertible Notes Issued by LICs
Convertible Notes issued by LICs are secured by the underlying portfolio. The crucial factor for investors is the level of gearing in the portfolio. For instance, if a LIC with $100 million in Net Tangible Assets issues $30 million worth of notes, it becomes highly enticing to investors. Their primary concern is that the company has $30 million in liquid investments at the end of the Notes’ term.
While some companies may lack certainty in this regard, most LICs are expected to maintain such liquidity. In the aforementioned scenario, it would be catastrophic for a portfolio to plummet from $130 million (taking into account the $30 million worth of shares purchased) to below $30 million, which would put the noteholders’ investments at risk.
The key aspect that Noteholders seek is the long-term performance of the investment manager, investment into reasonably liquid assets, and a conservative level of portfolio gearing.
Flagship Investments: The Ideal Structure for Convertible Notes
Flagship Investments issued Convertible Notes in October 2021, raising $20 million. These Notes trade on the ASX under the code “FSIGA.”
FSIGA represents a redeemable Convertible Note that pays quarterly interest at a rate of 5.50% per annum until September 30, 2024. If, at that date, the 2-year Bank Bill Swap rate exceeds 1.285%, a “Step Up” provision will trigger, increasing the interest payment to 6.50% per annum.
The $20.0 million FSIGA issue represents FSI’s only outstanding debt facility, resulting in a pro forma net gearing ratio of 32.0% (net debt/shareholder’s equity) at the time of its launch.
FSI Convertible Notes: Best of Both Worlds
Flagship Noteholders have two options upon the term’s conclusion in September 2026. They can either redeem the Note for cash, receiving the face value of $2.70 per note, or they can convert the Note, on a one-to-one basis, into shares of Flagship Investments Ltd (ASX: FSI).
Considering that the NTA per share as of May 31, 2023, exceeded $2 ($2.06), it is possible that the shares may be valued higher than $2.70 upon the Notes’ maturity in September 2026. This “embedded call option,” providing the ability to convert the Note into FSI shares, offers additional value for Noteholders. Interestingly, Noteholders often choose to convert their Notes before the term’s end to access the dividends and franking credits that the LIC distributes to shareholders.
Acquiring Flagship Convertible Notes at a Discount to Face Value
In mid-June 2023, FSI Notes traded on the ASX at a price of $2.59 per note. This implies that investors could purchase Notes with a face value of $2.70 for $2.59, offering a slight discount.
Furthermore, similar to the yield enhancement experienced when acquiring discounted LIC shares, the 5.50% per annum interest payment provided by the Convertible Note is based on the $2.70 face value. Consequently, buyers receive a yield of 5.73% on their convertible note.
Enhancing Yield, Capital Growth, and Optionality
In addition to the already attractive 5.50% per annum yield, investors who acquire the Notes below the face value of $2.70 will experience capital appreciation at the end of the term if they choose to receive the cash payment of $2.70 per Note. Moreover, they retain the option to convert the Note into FSI shares if desired.
Convertible Notes in LICs: The Ideal Investment
Whether it is Flagship Investments or another LIC that offers Convertible Notes, investing in a LIC is a remarkable opportunity.
These Notes offer a high level of capital security, regular and reliable income streams, potential yield expansion when acquired at a discount, capital growth potential in face value, and the flexibility to convert into the company’s underlying shares, which may be trading above the face value of the Note.
Consider the merits
All these aspects provide investors with reassurance that while the Notes they purchase may occasionally trade below face value if sold before maturity, there will likely always be a buyer for them. Moreover, at the end of the term, the capital value should remain secure.