Can a single company bond help you beat inflation?

22nd February 2013

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Historically, investing in the bond market was confined to a select few. Companies have issued bonds through the capital markets, where they were bought by fund managers writes Cherry Reynard.

If investors wanted exposure, they had to go through a collective investment scheme. But, under pressure from private investors and stockbrokers hungry for new sources of income, many companies have decided to launch bond offerings direct to the public. They have been wildly popular, but should investors be
wary?

On the face of it, retail bonds seem like a welcome democratisation. Companies are cutting out the middle man, usually an investment bank, and going direct to the public. This makes sound economic sense; investors are saving themselves the cost of the investment bank’s cut.

Equally, the yields can be seductive. The list of retail bonds is available here: Londonstockexchange – and shows that there are attractive blue chips bonds available, such as GlaxoSmithKline paying a 5.25 per cent yield for a 20 year bond or Rolls Royce paying 7.375 per cent for a five year bond. All investors have to do to get that yield is invest for five or ten or twenty years, hope that GlaxoSmithKline or Rolls Royce doesn’t go bust (unlikely), collect their coupon year after year and get their money back at the end of the term.

There is a wide choice of bonds available, as more companies have seen the merits of going direct to consumers. Alongside all the major blue chips – Tesco, Severn Trent, National Grid – there are a range of higher risk, but higher income companies such as food chain Leon. This ‘thisismoney‘ piece outlines how the market has developed.

There can even be an ethical stance to some of the bonds available. A recent scheme has been launched by Mencap, and is outlined in the Guardian. It pays 4 per cent a year and is aiming to raise £10m to buy homes for people with a learning disability.

It is easy to see why this appears to be an attractive alternative to a savings account. After all, some of these bonds are offered by the banks. Investors could put £10,000 in a savings account with the same bank and receive half the income. Both would, theoretically, be exposed to the bank going bust, but one pays the investor a whole lot more.

But therein lies the first wrinkle: Unlike a bank account, retail bonds are not subject to the Financial Services Compensation Scheme. Investors have no protection if a company fails and they lose their money.

This is one of a number of problems specific to retail bonds. Investors may find it difficult to get in and out. There is not a problem if an investor is simply going to buy a bond and hold it until the end of its term. But 20 years (in some cases) is a long time to tie up cash, so what if they need their
money back? There is a secondary market in these bonds that allows people to sell out, but liquidity is relatively thin. This means investors may have to take the price that’s offered to them.

The risk of default in a retail bond may not be all it seems either. Stephen Snowden, manager of the Kames Investment Grade Bond fund says: “In some cases retail investors receive a lower yield than institutional buyers, and in some cases they take on materially more default risk.” He points to National Grid bonds, where the retail bond was issued out of the parent holding company, in contrast to the institutional bonds, which were issued out of the UK regulated operating company.

“So does this make any difference? The answer is yes. There is materially less default risk for example in owning a bond issued out of a regulated UK operating company than there is owning a bond issued out of parent holding company. In the UK, Ofgem regulates gas and electricity companies, and importantly restricts their ability to burden themselves with debt. The UK simply cannot risk waking up one morning with the electric or gas switched off because the utility company has gone bust – this is very sensible. That regulatory debt protection however is not extended to the parent holding company, which could in theory become extremely highly geared to boost shareholder returns.”

These risks are specific to retail bonds, but there are also risks to bond markets generally. The biggest risk is a rise in interest rates. This makes the coupon on a corporate bond less valuable and causes the price to fall. Again, this is not a problem if investors simply want to hold to the end of the term, but could give them problems if they want to sell in the secondary markets.

There is also the inflation problem. David Coombs, head of multi-asset investments at Rathbones Investment Management, points out in this that one of the greatest threat to investors of bonds is inflation. Speaking to the Financial Times, he said: “If interest rates rise, the market value of bonds is likely to fall as their the coupon rates start to look less attractive. Coombs advises clients to think carefully about the current risk to reward ratio. “We have already begun reducing exposure to corporate bonds.”

Investors receive a fixed rate and that remains in place whatever the external conditions. A rate of 5.75 oer cebt to tie money up for 10 years looks good when inflation is 2.7 per cent and savings rates are at 2.5 per cent.
But would it look as good when interest rates are at 5 per cent and inflation is at 2 per cent? Again, this would also damage the value of the bonds in the secondary market.

Investors also have to weigh up dealing costs. For retail bonds, they will pay stockbroking charges – a fixed amount per transaction. Investing in corporate bonds via funds carries an upfront and annual fee. One is not necessarily more expensive than the other, but investors need to take costs into consideration.

Although security can be seductive, GlaxoSmithKline shares currently carry a yield of 4.98 per cent and the potential for an appreciation in the share price. Tesco pays a dividend of 3.94 per cent. If money is being tied up for five, ten or even twenty years anyway, investors have time to ride out the market cycle. Shares also offer some inflation protection. Retail bonds have their place, but it is also worth thinking about the alternatives.

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