Shaken, not stirred?
William Reid looks at the role of corporate bonds in charity portfolios...
Over the last 10 years the average charity has reduced its overall asset allocation to bonds from 17.4 per cent to 10.9 per cent, a move of 6.5 per cent.1 Over the same period, the average annualised return on corporate bonds was 1.1 per cent higher than that achieved by UK equities and Government bonds (gilts)2. Last year was a very different story, with the ‘credit crunch’ providing extremely testing market conditions for corporate bonds, whilst gilts benefited from the ensuing ‘flight to quality’. Is now, therefore, the time to increase exposure to corporate bonds?
Key attributes of corporate bonds
Corporate bonds are issued by companies to raise funds and are typically either secured against company assets (debenture stock) or are unsecured (loan stock). Governments can also issue bonds, called gilts in the UK, and these are considered the safest form of investment after cash – the return available reflects the lower degree of risk. As well as conventional gilts, the UK government also issues index-linked gilts, offering a degree of protection against inflation.
Bonds and gilts are expressed by their coupon, name and redemption date, such as 5.5 per cent Royal Bank of Scotland, 3 December 2019. The coupon is the annual gross interest rate on the nominal value of the stock. The nominal value for the majority of issued stocks is £100 and this is referred to as ’par’. The value of the bond, after issue, is not fixed and can trade above or below par. The redemption date is the specific point in time when the holder will be repaid the nominal value.
The common risks faced by all bonds are interest rate fluctuations and inflation. Corporate bonds also face the risk of default, where the issuer is unable to pay either the ongoing periodic interest or the capital sum at redemption. This greater risk warrants a higher return than the equivalent gilt or bank deposit rate. Interest is most commonly paid at a fixed rate, but floating rates or a lump sum at maturity are other popular variations. The issuer may also have the option of calling the bond in early for repayment. Again this extra risk attracts a higher return.
An investor is more concerned about the security of the individual bond purchased rather than the indebtedness of the issuer’s whole company. Standard & Poor’s is one of several credit rating agencies that review the level of default risk involved, centred on the principal measures of capital and income cover. They provide bond ratings for the majority of issued bonds, broadly defined into two categories; investment grade (rated BBB or above) and subinvestment grade (junk or high-yield bonds). A high-rated bond has a lower perceived risk of default and hence a lower yield. However, Enron and Marconi demonstrate that this is not an exact science.
Pricing and returns
The bond’s running yield expresses the annual interest payments in relation to the current market value, in percentage terms. Thus, it purely measures income return and ignores the effect of capital loss or gain on a stock if held to redemption. Conversely, the gross redemption yield takes this effect into account and thus is a true measure of total return. If the bond is trading below par, the gross redemption yield will be higher than the running yield and vice versa.
A bond’s price fluctuates according to changes in market conditions or credit quality, with changes in the level of interest rates typically having an immediate, and predictable, effect. If interest rates are lowered, prices of outstanding bonds rise as investors drive prices higher to lock in higher interest rates. The converse is also true, rising interest rates make existing bonds look less attractive and prices fall.
There are two key determinants in assessing a bond’s volatility to interest rate movements. Longer-dated bonds are more sensitive than shorter-dated bonds. And low-coupon bonds are more sensitive than high-coupon bonds. Modified duration is the standard measure of this volatility or price sensitivity and shows the expected change in price for a 1 per cent change in interest rates.
Benefits and risks
There are several benefits and risks when investing in corporate bonds and gilts. They have a low correlation with equities and are ideally suited to offer diversification within a portfolio. Bonds should yield more than cash, reflecting the increased risk and allow buyers to lock in a higher income; an attractive proposition for funds constrained by income. However, interest payments are the same irrespective of inflation and thus the bond has declining purchasing power, whereas equities may increase with inflation and dividends may also rise. There is also limited scope for capital appreciation, unless the stock is purchased below par.
Interest on debt is payable irrespective of whether the company is profitable, whereas dividends on ordinary shares are only payable on distributable profits. In the banking sector, at present, a number of companies are holding rights issues, effectively cutting the dividend and paying the interim dividend in scrip form. Thus holders of equity will see a fall in income while bond holders remain unaffected. Furthermore, if a company fails, the holders of equity are last to recoup their investment and in many cases receive nothing. A bond holder, however, depending on the capital priority of the bond held, stands a real chance of receiving back some, if not all, of their original investment.
The last 12 months have demonstrated that, on several occasions, in times of extreme stress the gilt market remains open for business whereas corporate bonds and equities can become difficult, if not impossible, to trade. Trustees should therefore consider the attraction of holding gilts in such a scenario, especially if there is likely to be a short term funding requirement that may require the liquidation of part of the investment portfolio.
The end of the ‘nice’ era (noninflationary constant expansion) and threat of rising inflation makes fixed-rate bonds less attractive as returns have no inflation hedge, unless index linked. Companies now face cost push inflation and if these rising costs cannot be passed on, profit margins are eroded and the risk of default rises. This may lead to a credit downgrade and a fall in the bond’s market value. Central banks are likely to increase interest rates in due course to contain inflation. The result is that for the majority of investors, over the medium to long term, bonds remain out of favour.
Markets, though, are taking an apocalyptic view on likely default rates. These are currently significantly higher than those witnessed in recent recessionary periods (1986-1991).3 An implied default rate on ‘AA’ bonds of 13 per cent, versus the worst recorded of 1.8 per cent, implies that sections of the market are offering attractive, mediumterm returns. However, charities are well advised to avoid direct investment in the ‘alphabet soup’ such as CDOs and ABCP that many cite as a cause for the market’s current predicament.
How to purchase bonds
The amount to invest will depend on the specific charity’s requirements and attitude to risk.
Purchasing gilts direct can offer the most pragmatic method in matching future liabilities. If individual corporate bonds are purchased, particular attention should be paid to the redemption features, credit quality and equivalent ‘risk free’ returns available elsewhere. Sector exposure, across asset classes, must also be taken into consideration to avoid unintended concentration. Stock-specific risk is diversified by holding a range of stocks, ensuring that attention is paid to both the maturity profile and duration risk of the whole bond portfolio. Direct holdings are generally not suitable for the smaller charity as it is a challenge to achieve appropriate diversification.
Common Investment Funds (CIFs) are well known and currently a dozen provide charities with an affordable means of investing in bonds. As with any investment, past performance is not an indication of future returns and it is essential to ensure that trustees are comfortable with the investment style and risk profile of the fund. Total expense ratios (TERs) within the CIFs range from 0.28 per cent to 0.91 per cent.
Unit trusts/open-ended investment companies (OEICs) can provide broad exposure to both corporate bonds and gilts. Again, pay attention to style, risk profile and TER. An option is to blend a portfolio of direct gilts with a higher risk fund to achieve a higher overall return, commensurate with risk.
Closed-ended funds (investment companies) can provide greater flexibility than OEICs in illiquid market conditions, to the benefit of long-term investors. This is especially true for ‘vulture’ funds.
Exchange Traded Funds (ETFs) trade like normal shares yet provide the ability to track an entire bond index. They take into account both capital and incomes returns and have low TERs.
The end of the ‘nice’ decade and the fear of rising inflation is a genuine concern to bond holders. Charities now need to consider alternatives in meeting long-term income requirements, balanced against the diversification benefits proffered by fixed-interest securities. In the short term, the pricing of implied default rates may warrant a tactical increase in allocation to bonds, achievable in a number of ways. Either way, the only certainty is that credit markets are no longer ‘boring’.
1 WM Company, Annual Review 2007.
2 Barclays Equity Gilt Study 2008.
3 Source, Deutsche Bank as at 18 April 2008.
Author: William Reid
William Reid is a partner at Cheviot Asset Management, where he specialises in investment portfolio management for charities and high net worth individuals.
www.cheviot.co.uk
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