Cash & Liquidity ManagementInvestment & FundingCorporate Bonds and Getting the Best Out of Them

Corporate Bonds and Getting the Best Out of Them

As an investment advisory firm it is little surprise that we are often asked by clients for additional ideas on income. With UK interest rates at 0.5% since March 2009, the European Central Bank (ECB) cutting the eurozone rate to a similar all-time low earlier this month, and little sign of any hardening of rates in the near term, holding cash has become less and less attractive. It is necessary for some corporates to maintain liquidity but there are alternatives to just sticking it in a bank account and plenty of excess liquidity that can be invested in companies offering corporate bonds. Other treasuries may want to raise cheap finance via this route as Apple has recently done. Retail investors are certainly keen customers, waiting to snap up many of these bonds.

As professional investors concentrate on the return on capital, rather than the previous requirement for the return of capital, the financing landscape is changing. Shares are an obvious asset class of choice for retail investors, but for the more open-minded corporate bonds are an interesting alternative for investors. Treasurers should be aware of the intense interest in their offerings at present and act accordingly.

The merits of cash generative companies in times such as these are clear and, indeed, the FTSE100 companies in the UK are on average currently yielding around 3.4%. For those investors willing to take a higher risk attitude compared even to holding equities, corporate bonds continue to be an investment destination of choice.

Of course, companies issue bonds to finance operations. But why not simply borrow from the bank some retail investors ask? There are many reasons why not, such as the restrictive covenants which a bank loan can entail, the generally higher costs (particularly for smaller companies) and, arguably, the fact that the bank’s major focus is the repayment of the debt, not necessarily the case with bondholders. There is also greater reticence on the part of the banks to lend so freely following the financial crisis, and the subsequent requirement for them to strengthen their capital cushions, driving more demand.

The New Financing Landscape

The market has opened up to the retail investor more and more in recent years. Up until 2010, when the London Stock Exchange (LSE) launched its retail bond market, the minimum investment had tended to be in the order of £50,000.

Now, however, corporate bonds are priced in £1 nominal units on the LSE and are often subject to a minimum investment of £1,000 nominal. Potential investors should be aware that away from the blue chip bonds, liquidity can be a slight issue (the spread between the buying and selling price being slightly higher). Even so, the fact that bonds are tradable and therefore have a ‘life of their own’ means that the client is not forced to hold them until maturity. In other words, the commercial paper market is now bigger and more established than it has ever been.

Why Retail Investors Are Targeting Corporate Bonds

Corporate bonds have a (usually) fixed rate of interest which they pay and have a set redemption date when the investor should receive the return of their capital. As a general rule of thumb, corporate bonds are categorised as having ‘investment grade’ status (having a higher rating as awarded by commercial credit rating agencies) or high yield (popularly ‘junk’ bond) status.

The reason that corporate bonds carry a higher risk is that they are, by definition, allied to the company which issued them. Interestingly, in the event of a company being wound up, they rank ahead of ordinary shares in terms of repayment and are in this way lower risk than ordinary shares. It is this possibility of default which accounts for the higher risk nature of corporate bonds, and is also usually accompanied by a higher return to compensate for this.

Nonetheless, investors should look at all available clues as to the creditworthiness and history of paying debts of the company in question. They may also take some comfort if the bond is one with a higher rating from the likes of credit ratings agencies (CRAs) such as Standard & Poor’s (S&P) or Moody’s.

In terms of Hargreaves Lansdown’s advisory, we have seen a great deal of interest from retail investors – generated by the current low income environment – and a number of new issues of bonds have been oversubscribed. Among the most popular UK corporate bonds currently being purchased are Provident Financial offering 7% at 2020, Tesco Personal Finance at 5% for a 2020 maturity, and the LSE Group at 4.75% for 2021 maturity. There is also Unite Group at 6.125% 2020. Our holders run into thousands and the amounts invested into the tens of millions. All this is useful money waiting to be scoped up by corporate treasuries. For example, my fund colleagues are currently in favour of the Royal London Corporate Bond, where the managers expect relatively weak economic progress in developed countries this year. They expect growth to be hampered by the need for governments to improve their finances in addition to on-going tensions in the euro zone. The UK corporate bond market delivered strong returns in 2012, although past performance is not an indicator of future performance. The managers believe, however, the prospects for bonds in 2013 are more modest.

Alternatively, the Invesco Perpetual Corporate Bond is another favoured choice. Here, the managers expect growth to remain subdued and low inflation to persist. In this environment they expect fixed interest returns in 2013 to be positive but unspectacular, with income forming the bulk of returns. They continue to believe financials are the main area of relative value in investment-grade corporate bonds, with rising capital levels, on-going structural reform and implementation of new, more conservative banking regulations remaining supportive of the banking sector over the medium term.

Inflation-linked corporate bonds can also negate the inflation risk for retail investors, making some treasury-released bonds more attractive still.

Corporate bonds are not without risk, however, and in general a higher yield has an explanation as described above in that there is risk somewhere. The performance of the bond will remain closely linked to the fortunes of the underlying company – and indeed inversely with interest rates – so investors should do their research carefully. Nonetheless corporate bonds do provide at least an income opportunity, which is increasingly difficult to find in times such as these. That is why corporate bonds are so popular at the moment.

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