as a primer on basic investment analysis and the ongoing challenge of balancing risk and reward, this email exchange tries to demystify the increasingly lucritive but often frigtening world of “structured finance”. caveat investor…

layer-cakeFrom: [a good friend]
Sent: December 20, 2005 9:56 AM
To: [me]
Subject: Can you please look at this prospectus?

My father is interested in this but thinks it may be too good to be true. What is your opinion?

From: [me]
Sent: December 20, 2005 11:14 AM
To: [a good friend]
Subject: RE: Can you please look at this prospectus?

it’s called “structured finance”, and it happens all the time. think of the income trust as a really tasty cake. each individual layer of the cake is a different type of security, from presumably government-issued, fully secured AAA-rated debt, to more risky forms of corporate credit as low as A- (still “investment grade”…i believe “junk”/”high yield” starts at BBB/BB+)

basically, a big group of lawyers and financial engineers come together and effectively “cook” all of these various risks together, until the consistency of the “cake” is a weighted average of AA-. then they serve up slices of that same cake to the public (as units of an income trust), thereby offering investors exposure to the benefits of lower-rated securities (i.e. higher yields) while offsetting any increased risk with their higher-rated peers.

it’s like pairing up chunks of government issued debt (pretty much the safest instruments in the world) with the borrowings of risky private corporations, instruments you might not be willing to include in your portfolio were they not “wrapped up” with their bigger financial brothers. better yet, try to think of these hybrid securities as a box of delicious, chocolate-covered grasshoppers: something you might never otherwise consume if they weren’t slathered in something you already love.

the best place to look in any prospectus for an understanding of the risk involved is a section called “risk factors” (in this case, you can find it on page 61…despite what it says in the table of contents) this is where the lawyers all get together and cover their collective financial hides, revealing every possible doomsday scenario that might somehow affect the promises they’ve made about your investment. for good companies, few of these “caveats” will ever play out, but for bad ones, almost all of them inevitably do.

which really takes us back to the inherent risk of investing in pretty much ANYTHING…your willingness/ability to absorb a certain amount of risk, in the hopes of achieving a certain amount of reward. in this case, your weighted average risk is AA- (just below Government of Canada debt, and about the rating of most Canadian provinces), and your reward is a “risk-free” AAA rate (say 3-5%) plus an additional 4-5% to compensate for that portion of the risk below AAA to which the trust is giving you engineered exposure.

basically, it’s hoping to structure an approximately 10% return on an ongoing basis through 2010, while taking a portion of your investment as management fees to fund the ongoing “tweaking” of the trust’s constituent securities. if you’re happy with a bunch of guys designing a software program to invest in derivatives that will, when combined, offer that particular rate of return, then i say go for it. it’s basically insurance, something i’m sure you dad understands quite well. the only difference is that P&C deals with tangible collateral, while this instrument is simply a bunch of dancing financial risk.