We all like bonuses. So when an investment says that if you invest now you can make an "interest rate bonus" on top of the regularly promised...
We all like bonuses. So when an investment says that if you invest now you can make an “interest rate bonus” on top of the regularly promised return, it’s enough to turn heads.
Recently, those heads have been turning to newspaper ads and direct-mail appeals to hype the bonus return on “renewable unsecured subordinated notes” issued by Consumer Portfolio Services (CPS).
While the additional return looks good on paper, it is the kind of siren song that turns the Consumer Portfolio notes into a Stupid Investment of the Week.
Stupid Investment of the Week highlights the concerns and characteristics that make an investment less than ideal for the average investor, in the hope that showcasing danger in one instance will make it easier to root out elsewhere.
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While obviously not a purchase recommendation, neither is this column meant to be an automatic sell signal, as there may be times when dumping an investment simply compounds the problem.
In the case of the CPS notes, getting out can be tough, as redemptions before maturity are limited and carry stiff interest-rate penalties.
But it’s the bonus, not the penalty, that attracts the attention of average investors.
Currently, according to materials issued by Sumner Harrington, the Minneapolis firm acting as agent for CPS, investors buying at least $5,000 worth of notes will get a bonus rate. The longer the lock-in, the bigger the bonus, so that a five-year note with a base rate of 9 percent will pay a bonus of 1.75 percentage points for anyone who buys by Dec. 30.
The CPS notes have base rates that currently run about double the average bank certificate of deposit for the same duration, and that’s before the bonus rate is added on.
But anyone who thinks they might use this kind of note to replace a CD doesn’t understand the product, and that is a big part of the problem.
“Renewable unsecured subordinated notes” are a mouthful, so think of them like this: “small-scale junk bonds.”
The debt is unrated, uninsured and has no trading market, meaning there is no liquidity.
Most important, if the Consumer Portfolio goes belly-up, any money left goes to senior investors first.
With significant debt, it’s a pretty safe bet that if the company implodes, there won’t be anything left for the lowly guy who bought unsecured junior debt.
Which brings the analysis down to the company itself. Consumer Portfolio Services (ticker: CPSS) is a distressed financial-services company that makes auto loans to borrowers with “subprime credit,” which means the kind of financially troubled consumer whose credit is impaired to the point they must pay higher rates for being a bigger credit risk.
Of course, that is exactly what the parent company is doing by issuing these notes: It is paying high rates because it’s a credit risk.
Most firms only consider taking this unusual direct-to-the-public step because they’re having a tough time raising money in the traditional equity and debt markets.
What’s more, “bonus rates” tend to be a siren song. Strapped borrowers typically tend to raise rates as they get more desperate for cash; investors sucked in by the promise of the bigger return wind up crashing on the rocks if the company’s financial position doesn’t improve.
The last subprime lender to issue notes like these was American Business Financial Services; the notes paid attractive bonuses right up to the point where the company went bankrupt and defaulted on its paper.
Morningstar can’t give a financial health grade for CPS, due to a lack of balance-sheet data, but the company gets a profitability grade of F. One positive; it gets a B+ grade from the ratings firm for growth.
Investors in the notes will be counting on that growth to continue. Shares in CPS have risen dramatically over the past four years, gaining 52 percent in 2002, 71 percent in ’03, 31 percent in ’04 and nearly 20 percent this year — but that will not help the investment notes. Savvy investors know that certain stocks may have good prospects, but the debt from those same companies might not be quite so good.
“You have to look what is the chance that this company goes out of business, changing hands or goes through some sort of trouble during the time for which you have the note,” says Ed Elverud of Sumner Harrington. “If you are comfortable that the company will still be in business when the note matures, you might be able to be comfortable investing.”
That’s one reason why investors can’t help but be tempted by one-year rates of 7.5 percent (bonus included).
The presence of Sumner Harrington is a plus, too, as the firm has never handled notes that the issuer defaulted on.
Elverud says the bonus rates have more to do with making sure the offering draws enough investors based on the cost of soliciting new buyers, rather than because of any desperation from CPS. Indeed, the company’s results appear to be improving, albeit slightly.
In addition, Sumner Harrington makes sure that investors don’t get overextended in these high-risk junk notes. Elverud notes that the average buyer of CPS notes — which were issued without the bonus beginning in May — is 58 years old, has a net worth of $1 million, and has been investing in stocks for 15 years and bonds for seven. That average investor has put $18,000 into the notes.
But that also shows the typical person buying these investment notes is hardly the average investor reading the paper and wondering whether the rate bonus is worth a shot.
“It’s not for everyone, and it’s definitely not something you would want to do with too much of your money,” says Elverud, “but we think it has a place for some investors.”
In the newspaper, the renewable unsecured subordinated notes from CPS look like a simple product, a safe alternative to the stock and bond market. In reality, they’re a high-risk product; an investor who understands mostly “big yield and a bonus” doesn’t know enough to buy them.
Chuck Jaffe is senior columnist for MarketWatch. If you have a suggestion for Stupid Investment of the Week — or a comment about this week’s column — you can reach him at jaffe@marketwatch or Box 70, Cohasset, MA 02025-0070.