3.Long term savings - The opportunities and risks - Bonds (part 2)

Wednesday, 11th May 2016 09:31 - by David Harbage

Essentially, when interest rates eventually rise, the fixed coupon income of gilts will appear relatively less attractive and the capital values of such bonds (especially those not protected by imminent redemption) must inevitably fall, as their yields reflect a market offering higher rates.

However, by contrast with conventional gilts, the appeal of index-linked government stock may rise if inflation picks up (to exceed the Monetary Policy Committee’s targeted level of 2%) to partially offset an increase in interest rates (towards what might be viewed as a longer term level of a Bank or base rate of say 3%).

Higher paying bonds issued by companies with strong balance sheets and successful businesses (in particular generating sustainable profits) may have more appeal as, unlike gilts, the market does not appear to have overvalued these assets to the same extent. As an example a gilt due to redeem in 10 years’ time currently offers a return (expressed as a GRY yield) of 1.5%, whereas the market is pricing an HSBC bond and an Imperial Tobacco bond of very similar maturity to offer a yield of 5.5%.and 4.5% respectively. If you prefer to avoid banks or tobacco companies, then bonds from less economically sensitive utility businesses yield around 4% (choose from most of the UK’s biggest, including National Grid, Scottish Power or Thames Water). However, if a pickup in interest rates is inevitable, surely the attractions of any fixed income investment must diminish – including higher yielding bonds issued by our largest firms?

The universe of investment grade quality sterling corporate bonds before the financial crisis of 2008-09 featured a yield of 5%, based on an average duration of between 7-8 years. At that time, gilts of the same maturity offered circa 3.5%, which suggests that the risk premium (the additional yield paid to take the risk of investing beyond the equivalent conventional risk-free gilt) was 1.5%. Currently, that premium has extended to 3% - which reflects deterioration in the economic backdrop, and weaker sentiment towards financial issuers. While gilts appear expensive and yields might be expected to rise by 1%, on any move towards normal levels of economic activity (and with it inflation and interest rates), the financial health of the corporate sector is probably stronger than current market valuations imply. Accordingly, the risk premium of investment grade bonds over gilts could fall by 1% - offsetting the suggested 1% pick-up in gilt yields - and effectively underpinning the worth of corporate bonds.

For those investors who are uncomfortable with the notion of company bonds but are seeking higher risk-reward fixed income issues, they might wish to consider 10 year sterling denominated European Investment Bank paper (a bond backed by governments, including the UK) which yields 2%. As you can see, dear investor “you pays your money and takes your choice” along the risk-reward spectrum if you wish to acquire a 10 year interest rate. Last, but not least, an investor can seek to minimise issuer – and to some extent duration (by reference to how exposed one is to longer term interest rates) - risk by choosing a ‘basket’ of bonds, via a fund (a managed unit trust or an index-based exchange traded vehicle).

In summary, for long term savers or individuals looking to invest beyond (overnight, or no notice) cash, via London Stock Exchange listed and traded securities, these are some of the prime opportunities and their potential shortcomings:

1. UK government bonds (gilts) have a life of between a few months, through to being undated (no set redemption date). These conventional bonds typically pay a set income half yearly, and are redeemed at par (£100 per £100 nominal amount of stock). Heavily traded, their price will vary on a daily basis – reflecting the attractiveness of the gilt, relative to its alternatives – but, backed by HM Government, reliability of return is high. Current gross redemption yield (GRY) on the 10 year gilt is 1.5%.
2. Other government backed issues may not enjoy the high AAA credit rating ascribed to UK gilts, and as such may offer a higher GRY. Currently the European Investment Bank (EIB) 10 year £ bond pays 2%, but other individual European country government debt issues – such as lowly rated, higher risk-reward, junk status Greece (10 year is currently 11%) - may offer considerably more GRY, reflecting investors’ lower confidence in the issuers’ ability to meet their obligations.
3. UK government bonds whose returns are linked to domestic inflation. Biased towards (tax-free) capital returns, these bonds are more sensitive to interest rate, as well as inflation, expectations than conventional gilts of comparable maturity.
4. Corporate debt typically features bonds issued by large companies (sometimes termed Eurobonds), can range from being backed by assets through to being wholly unsecured, and incorporates various forms of company capital – from debentures to preference shares, through to permanent interest bearing (PIB) shares. Assessed by the credit agencies, investment grade quality (rated BBB or better) 10 year sterling denominated corporate bonds currently offer a GRY of 4%.
5. Beyond individual bond issues, investors seeking diversification may be interested in collective vehicles. Exchange Traded Funds (ETF) – such as the i share £ Corporate Bond fund – which replicates an appropriate universe or index of bonds issued by multinational or domestic companies, may be worthy of investigation. This £1.5bn passive tracking fund currently holds 330 different bonds with an average coupon of 5.3%; yielding 3.6%, with a maturity of 13.5 years and a duration of 8.6 years. An actively managed fund, by contrast with the above ETF, is likely to seek outperformance of a particular bond index or other benchmark.
6. Prime risks or negative factors surrounding bonds in general: firstly, the attractions of such fixed income investments reduce if interest rates (both overnight Bank and longer term rates) are rising. Accordingly, the long term saver should take a view on the direction of interest rates, the extent to which they are set to move, and when that will happen. Similarly, the investor wishing to take-on the risk of corporate bonds – in addition to, or instead of, gilts – will need to form a perspective on a company or the wider economy’s financial health, as well as have an appreciation of the historic relationship (in terms of relative value) with gilts in particular. Secondly, if inflation is high, investors should consider alternative assets in order to preserve the real worth (or purchasing power) of their capital.

Next week we will begin to take a look at assets which can provide some protection, in both capital and income terms, from high inflation. And, as ever, seeking to diversify and provide a balanced independent perspective on the financial landscape which the private investor faces.

David Harbage

26 February 2016

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.