The dangerous game you play with bonds

Today, I want to pick up on a thought thrown up from Monday's article. It set me on a bit of a research mission and what cropped up is of great importance to anyone investing in equities and bonds.

What's best: equities or bonds?

On Monday, I said that there's a major danger facing many of the UK's top businesses. And the danger is that many trimmed-down businesses are committed to out-sized pension liabilities.

I even went as far as to say that's exactly what BT's got. And it threw up an interesting comment from a BT bondholder: "I hold BT 2028 bonds and I expect to get my money back."

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And the reader has a good point.

Bonds are a different animal to equities. Rather than paying a dividend, bonds pay holders a fixed amount of interest. And, like a company's pension liabilities, these interest payments are obligatory. BT can't weasel out of paying their bondholders unless it goes bust, that is.

Dividends, on the other hand, aren't obligatory. They can be pared back, or suspended if need be.

And BT has a pretty patchy history on dividends, as the following table shows.

BT's dividend history since 1999

Just look at how dividends suffered following the dotcom collapse of 2000, falling from 20.4p to just two pence. And then having gradually built the dividend back up, it got trashed again in 2009, falling from nearly 16p to less than 7p.

Clearly, that's not a great track record. BT currently yields about 3.5%. Though analysts hope it should increase over the next couple of years. They're pencilling in a yield of 5% by 2013.

Source: Digital look

But, if the financial markets turn down and BT's pension deficit grows, they'll have to divert company profits to the pension fund. And that could put dividends under pressure.

So, what about the bond? Well, the bond held by our reader pays 5.75%. So even if BT can raise the dividend to nearer 5%, the bond still looks good. And unlike the vagaries of your equity dividends, the bond yield is fixed.

But there's something that I don't like. This bond issue won't be redeemed until 2028 that's when holders get their initial capital back, all they got up until then is the interest. Now 2028 is a long way off.

I wouldn't want to commit my money for that long. If inflation becomes entrenched, it can take a nasty swipe out of that yield.

So it got me thinking. What if BT has a shorter dated bond? Maybe I could go for that.

The 2016 looks like a great bet -at first!

And I found one. At first glance it looks pretty good.

The BT bond I looked at has a fixed rate of interest paying 8.5%, and matures in December 2016. But before you get too excited, that 8.5% is based on par value of £100, ie when the bond was launched back in 1999, investors demanded £8.50 a year for each £100 invested.

But of course, today rates are much lower and that 8.5% is too much. Because markets don't stand still, you'll find that if you want to buy this bond, you'll have to come up with £122 (for every £100 nominal).

But if you pay £122 for the bond, it means your yield is lower. In fact it gives you a running yield of around 7%. That is £8.5/£122 = 6.9%

Still looks pretty good, huh?

BUT, hold your horses. There's something of paramount importance.

In fact, this bond shows you brilliantly a nasty death trap for unsuspecting bond investors.

How about you halve the interest rate!

This bond matures in five years time. And when it does, it will pay back holders £100 that is the amount initial investors lent BT in 1999. And if you've just paid £122 in the market, clearly you're going to take a £22 hit for every hundred units you hold.

What we need is another yield calculation to take this into account. Step up the 'gross redemption yield' (GRY).

Back when I did my City exams, I'd have to work it out the long way round. But today, there's a handy website that'll do the calculation for you. You can find it here. Put in the relevant bits of information, and this the gizmo calculates the GRY for your bond.

And you may be surprised at the results.

You see, that bond that at first looked like it was paying 8.5%, (which we adjusted down to 7% as we had to pay £122 for it) gets smashed in half.

Taking into account the £22 loss on redemption, your yield ends up at a more sober looking 3.6% a year.

Now that's quite a difference compared to the headline 8.5%!

Don't despair

I'm a big fan of bonds. I think UK private investors massively underrate them. Most investors seem to go for either cash or equity savings.

But there are bonds out there that will pay you much better rates of interest than you'll find on fixed interest high street products. And unlike many of their high street counterparts, you can sell these bonds if you need your money back in a hurry.

But from what I can see, BT's bonds don't fit the bill. Of the two I've mentioned today, one ties your money up too long and the other pays too little interest.

I previously told you about an RBS bond that I like with both inflation and deflation characteristics, and I'm still keen on that.

Otherwise, I'm still holding out for news on new corporate bonds coming to the market. I hear through the grapevine that we're likely to see new issues paying around 5% with maturities of around five to eight years. I'll let you know as soon as I get the details.

If you've invested in an interesting bond yourself, then let us know about it leave a comment below.

This article was first published in the free investment email The Right side. Sign up to The Right Side here.

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