The six risk categories identified and assessed (in order of importance) are:
The financial strength of the issuer is examined according to the sector in which the company operates. This is primarily designed to ensure the analysis represents a true reflection of the issuer’s financial strength and to take account of the fact that banks and insurance companies have very different financial structures than traditional industrial companies. Specifically, the key indicators analysed include balance sheet strength, wholesale credit rating, capital adequacy ratios, interest cover, asset quality, liquidity, net tangible assets, gearing and earnings quality.
The risks inherent in any listed income security can vary significantly based on the security structure. To assess structure risk, Lonsec examines subordination / capital classification, distribution payment tests, distribution restriction conditions and conversion conditions.
The risks associated with the maturity structure of the issue are examined in detail and a relevant risk rating assigned. One of the key factors in the market’s pricing of a listed income security is the maturity terms and conditions, as these determine the ‘how’ and ‘when’ the invested capital is returned to the investor. Lonsec forms a view on the expected maturity date of each security, having considered the maturity and / or conversion terms, the financial capacity of the issuer, the ascribed equity credit and the significance of the size of the issue to the issuer.
Liquidity risk is the risk that an investment may not be easily converted into cash with little or no discount to the last traded market value, and at minimum delay. A liquidity premium should be required by investors to compensate for lack of liquidity. Low liquidity can also result in higher than desired volatility. Key attributes analysed to rate liquidity include issue size and average weekly turnover.
Structural and operational risks associated with the industry in which the company operates can impact the financial position and prospects of the issuer, and hence the performance of the listed income security. Industry analysis involves consideration of the following factors: current and forecast industry conditions, domestic and global economic outlook and its expected impact on the industry, regulatory risks, the company’s positioning and pricing power within its industry, the power of suppliers and buyers, as well as the life cycle stage of the industry.
Volatility measures how much the market value of an issue fluctuates with respect to its face value over the life of the issue. Volatility is often viewed negatively in that it represents uncertainty, however, it can also provide the potential for higher returns. Both capital and income will contain some degree of volatility depending on the nature of the underlying investment. Our assessment of expected volatility takes into consideration a number of metrics including issuer strength, economic and credit market conditions, investor sentiment, equity market conditions, the perception of or likely occurrence of distribution deferral or a conversion trigger, capital ranking / structure, liquidity, conversion terms, maturity risk and the volatility of listed peers.
Refer to the methodology document for further information...