Before diving in to great-value deals in investment-grade credit, make sure you know what you’re getting into, says Tim Bennett.
Corporate bond markets are holding the sale of the century, it seems. “Prices have not been more favourable since the Great Depression,” says the FT’s Ellen Kelleher. Chris Bowie, head of credit at Ignis Asset Management, tells The Daily Telegraph: “investment grade credit has never been better value – ever”. The attractions are obvious. Investors hungry for decent returns, or yield, are increasingly short of options. Two-year gilt yields slipped below a pitiful 1% this week. Stockmarket investors are still reeling from last year’s FTSE 100 price drop of nearly one third, while dividends are being cut left, right and centre – housebuilder Bovis was among the latest to scrap its payout this week. As for cash, with the Bank of England base rate at its lowest level in more than 300 years, savers are hard-pushed to get any return at all.
Against all this gloom, typical yields on corporate bonds average between 5% and 7% on high-grade bonds and an eye-catching 10% or more on riskier high-yield bonds, says The Daily Telegraph’s Geoff Lunt. And even though we’re in a deep recession, the market seems to be pricing in something worse. The gap (spread) between the yield (return) on US investment-grade bonds – blue-chips, in other words – and Treasuries (US government-backed IOUs), hit a record in mid-December and is still “at levels last seen in 1932”, says Tim Bond at Barclays Capital. Analysts at Morgan Stanley estimate that prices for US investment-grade corporate bonds imply a default rate many times higher than the worst rate in any previous five-year period.
Of course, bond markets might be right to price in such a drastic scenario. Several big firms have already hit the wall in 2009, and the carnage will continue. There’s also the danger that deflation will be more short-lived than investors fear, pushing up yields across all asset classes (see below). Nonetheless, corporate bonds look attractive just now, but you have to make sure you choose the right way to get exposure to them – here’s how.
What is a bond?
A bond is just an IOU issued either by a government (‘gilts’ in Britain), or a firm. Say a company issues a five-year 8% bond. This fixed-income security pays the holder a pre-tax ‘coupon’ of exactly £8 every year for five years based on its ‘par’, ‘face’, or ‘nominal’ value of £100 (sometimes £1,000). The bond is then ‘redeemed’ or ‘matures’ in five years’ time, which is when the holder gets the nominal value back. Because the bond can be traded, the initial buyer could hold the bond for, say, two years, then sell it having banked a couple of coupons and perhaps a rise in price. That capital gain (or loss) arises because, once issued, the market price of a bond is set by supply and demand, so it may trade above or below its £100 nominal value.
Big British and global bond buyers tend to be institutions – pension funds, banks and hedge funds. Just as you’d expect, they are aiming for a decent return, taking account of the bond’s risk, and what they could earn elsewhere. As a rule of thumb, the less appetite these investors have for lending companies money by buying bonds – as was the case in 2008 – the lower prices go and the higher the yield. Hence the current opportunity to buy bonds cheaply.
The jargon
Bonds come with their own raft of jargon. First you get the name of the issuer – say, Tesco. Given that Tesco has issued many bonds, a broker may also quote a unique International Security Identification Number (ISIN), such as XS0159013068. Next comes the currency, say GBP (sterling). Now you get the coupon rate – say 5.5% – and maturity date of 13 December 2019, plus an indicative price of say 97.65. This tells you that the bond can be bought for £97.65 per fixed £100 of nominal value (just as in Tesco you can pay the market price for a fixed 1kg of carrots). You won’t do a deal at exactly £97.65 because, as with stocks, corporate bonds suffer bid-to-offer spreads – the buying price will be slightly above £97.65, the selling price slightly below. The riskier the bond, the bigger this gap and the more it costs you to trade. For example, Hargreaves Lansdown’s typical spreads on investment grade bonds are around 1% of the price, subject to a minimum £15 per deal (£10 if bought for an Individual Savings Account (Isa) or Self-Invested Personal Pension (Sipp)) to buy or sell. This rises to an eye-watering 6%-10% or more for riskier, less liquid bonds.
Income and gross redemption yields
How do you work out how much the bond will pay you? The first key number is the income yield – the annual coupon as a percentage of the current price. The Tesco bond above offers an income yield of 5.63% (5.5/97.65 x 100). Pure income seekers can compare this to the dividend yield on shares – but it doesn’t capture the total annual return. Pay £97.65 and hang on to the bond until redemption at £100 and you’ll make a capital gain too. The gross redemption yield (GRY) factors this in. The calculation is fiddly, but luckily brokers, websites, or the Financial Times will do it for you. As a rule of thumb, if a bond is priced below its nominal value – here £97.65 – the GRY will be above the income yield, thanks to a small annual capital gain, and vice versa. For the Tesco bond, the effect is to push the total yield closer to 6%.
Finally, you will sometimes encounter ‘modified duration’. Duration measures roughly how far you are from the bond’s future mid-point, in years. That’s the point when you will already have pocketed as much in coupons as is left outstanding in the form both of future coupons and that final £100 redemption payment. It’s a slightly tricky calculation, but in short, the longer a bond’s duration (for the Tesco bond it’s about eight years) the more sensitive it is to changes in interest rates. This means it should rise more rapidly than some other bonds with lower durations as the Bank of England rate falls and vice versa. Retail investors, unlike institutions, can’t hedge away this price volatility using derivatives such as swaps, so it’s best to understand what drives it – interest rates and maturity dates – before buying.
What moves prices?
Interest-rates risk is straightforward in principle. Imagine money market interest rates are 10% and you hold an undated (no set redemption date), low-risk 10% bond priced at £100. If interest rates double to 20%, the price of the bond needs roughly to halve (remember the 10% coupon is fixed) so that the bond’s yield can compete with, for instance, a cash account. So as interest rates rise, fixed-income bond prices tend to fall and vice versa. Broadly speaking, the lower the coupon rate, the more interest-rate-sensitive the bond (and the higher its duration because it takes longer to reach its ‘mid-point’).
Price sensitivity is also driven by the redemption date. Take a 10% bond, maturing tomorrow, priced at £99 when interest rates are 10%. The price won’t move much even if the interest rate doubles or halves. That’s because the bond will be bought back by the issuer tomorrow for a fixed £100, so the market price must be close to that £100. So, the closer you are to redemption, the less rate-sensitive the price will be (reflected in a lower duration). But price sensitivity isn’t the only worry. The issuer might go bust between the issue and redemption date – a very real threat at the moment. So you also have to grasp issuer risk.
Issuer risk
The first step is to check an issuer’s credit rating with your broker. Credit rating agencies such as Standard & Poor’s and Moody’s rate bonds from AAA down to D. Relatively safe, or investment grade bonds are rated BBB- (S&P), or Baa2 (Moody’s), or higher. Anything else is non-investment grade – also known as junk. As Luke Spajic, head of European credit strategy at PIMCO puts it, be “exceptionally careful” about high-yield bonds. While they are safer than shares (bondholders are higher in the pecking order than stockholders if a firm goes bust), you still might lose most, or all, of your investment in corporate bonds if a firm collapses. So stick to investment grade and above in the current recessionary climate, unless you’re a gambler.
Of course, as the subprime debacle showed, credit ratings can’t always be relied on. And S&P, for example, only stated that it “may” downgrade Lehman Brothers’ bonds days before the bank collapsed. So you must do your own checks on a firm’s accounts. Watch for any sudden dip in operating cash flows in the cash-flow statement. Then review interest cover by looking at pre-tax profit as a multiple of the interest charge, and, as a back up, the number of times cash flow from operations covers ‘interest paid’ in the cash-flow statement. While harder to do, the Altman Z score test for bankruptcy risk is useful too. In short, this combines five key accounting ratios to produce a single risk score. A score below about 1.8 is another danger sign. You can find a calculator at the UK Insolvency Helpline.
Also, don’t forget that unlike shares – which can double in a matter of weeks if you gamble and get lucky – corporate bonds are medium to long-term investments with little prospect of a sudden windfall. So safety matters. Especially given the “debt time bomb” identified by The Daily Telegraph’s Jonathan Sibun – a record £110bn of corporate debt becomes repayable in 2009, putting more pressure on firms. Just as high dividend yields can mean that a cut is around the corner, high bond yields do not necessarily signal a bargain.
Beware oddball features
You should also stick largely to ‘plain vanilla’ bonds. Different bonds from the same issuer can look superficially similar, for example, but only in the same way as a Porsche can be said to resemble a VW Beetle. Tesco – as John Patullo at Henderson Global Investors points out – has at various times had over 30 different corporate bonds in issue, compared to just one class of listed ordinary share.
And, unlike shares, bonds regularly come with quirks. These can change the way a bond behaves. Some contain embedded call and put options. This means they may be sold (‘put’) back to the issuer before redemption or repaid (‘called’) early by the issuer if, for example, cheaper financing becomes available. Either possibility can change the future coupon stream and expected yield. Then there are bonds where the coupon payment is based not on the firm’s total cash flows, but on, say, the income received from its property portfolio. Tesco has issued these in the past.
And then there are the banks. They sometimes build in an option not to redeem a bond on its due date, but to convert it into a similar issue with a much later redemption date. That’s the case with an oft-quoted Barclays bond that would otherwise offer a ‘no-brainer’ yield of around 14%. There are also potential coupon problems – these are paid before dividends, making them safer, but on some bonds the issuer may be able to defer payment if it has insufficient profits, a bit like a preference share. Indeed, what looks initially like a bond may even be a (less secure) preference share. Most big issuers also sell bonds in a range of currencies. These are called ‘eurobonds’, and expose you to currency risk too.
Finally, although corporate bonds rank higher than equities for interest payments and the return of your capital, the precise ranking can be complex. Other lenders, such as banks, may have a prior claim on a firm’s cash flows and assets via ‘charges’ or ‘securitisation’, for example. So high-yield debt in particular may offer a big yield to compensate for the relatively low ‘seniority’ of the bond. So if you plan to get into buying individual high-yield bonds in particular, you’ll need to read the prospectus containing all of a bond’s terms and conditions. If life is too short, and you don’t want to pay your broker to do it via a costly advisory service, buy a bond fund or an exchange-traded fund (ETF) instead.
Shopping for bonds
Buying individual corporate bonds is neither as easy, or cheap, as buying FTSE 100 shares. You can’t buy them online – you’ll need to phone a broker such as Hargreaves Lansdown (0117-980 9800) or Barclays Stockbrokers (0845-601 7788). Then watch out for minimum deal sizes – typically £1,000 nominal value. Don’t forget to ask how much £1,000 nominal of bonds will cost and always check the charges.
Lack of information is another challenge. Many corporate bonds aren’t listed at the London Stock Exchange in the same way as shares – the market is largely private, with deals done between institutions ‘over the counter’. Even if you pester a large broker, they’ll often only tell you about, or sell, bonds they can easily get hold of from a fixed-income market maker or hold themselves. See here for one of the more comprehensive retail bond lists.
And with many firms struggling to issue debt, liquidity for some bonds is what asset manager Richard Cheng at TIAA-CREFF calls “exceptionally poor”. That’s yet another good reason not to go in search of individual high-yield bonds – even if your broker can find them for you, the trading costs could be horrific. That’s also why buying anything with less than about five to ten years left before maturity can be unwise – the bid-to-offer spread will chew up a big chunk of your profits, and only corporate bonds with at least five years remaining to maturity can be held in an Isa or Sipp if you’re after income-tax savings on interest income (non-convertible sterling bonds usually escape capital gains tax, but always check this for specific bonds with your tax adviser or broker).
Lastly, always check the latest price before buying – with liquidity sometimes low and competition hotting up to buy corporate bonds, prices can move quickly. For some individual bonds that are worth a look, see below.
What to buy when it comes to bonds
For investment grade bonds, typical yields have dropped to around 5%-7% after issuance hit an eight-month peak of $41bn last week. Henderson’s John Patullo recommends investors stick to defensive sectors, such as utilities, telecoms and food retail. The General Electric 5.25% 2028 bond offers 7.6%, while the Tesco 5.5% 2019 also fits the bill, with a GRY of 5.2%. Meanwhile, Ian Robinson, director of UK credit at F&C, tips the BT 8% 2016, which yields around 7%, and the Marks and Spencer 5.625% 2014 yielding 7.7%.
But before diving in, bear in mind that we may only face deflation – which is good for bond prices – in the short-term. Governments are slashing interest rates to combat deflation, while Barack Obama is considering an unprecedented package of measures aimed at boosting the US economy. Should these work, the return of inflation can’t be ruled out and perhaps quite quickly. If you buy individual bonds now, then change your mind if inflation fights back, you could lose 2% or more of your early returns in dealing costs. Given that, and the fact that higher-yielding bonds are expensive and hard to trade, overall we favour a cheaper way to track long-dated, liquid corporate bonds. The iShares Sterling Corporate Bond Fund (LSE:SLXX) yields 8%. There’s no initial fee, the expense ratio is just 0.2%, and you can get in and out with ease. If you want exposure to high-yield debt, try the US dollar-denominated iShares iBoxx Corporate Bond Fund (NYSE:HYG), which yields just over 11%, with an expense ratio of 0.5%.
Lastly, there are managed funds, marketed as a good way to diversify risk as they buy a range of bonds. But you pay a hefty premium. The Henderson Strategic Bond Fund offers a yield of around 8%, having fallen by 12% last year. The initial charge is 4%, which can be cut by buying via a broker, and the annual fee is 1.25%. Or Hargreaves Lansdown tips the Invesco Perpetual Corporate Bond Fund, down 7% last year. The yield is 7.4%, the initial fee 5%, and the annual fee is 1%. We prefer cheaper ETFs.