The hidden dangers of investing in corporate bonds

Since the turn of this century, having your money in shares has rarely been a pleasant experience. In that relatively short period, we've seen two of the most severe stockmarket crashes on record. For many of those relying on equities to save for their retirement, the only way they'll have eked out any sort of return has been by collecting and reinvesting their dividends.

It's little wonder the patience and nerves of many investors have been tested.

In stark contrast, government and corporate bonds have done very well, which means they've also become increasingly popular. As Tanya Jefferies notes on Thisismoney.co.uk, the fixed-income sector has been the most popular destination for investors' money in each and every month this year, according to Investment Management Association data.

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It's not hard to see why. There's something quite appealing about investing in bonds. As long as the government or firm concerned doesn't go bust, you can buy £100 of debt, receive a series of interest payments for a number of years, then get your £100 back. Some bonds even try to protect you from inflation.

This means that when you get your money back, it might buy you the same amount of goods and services as it did when you first invested. On top of that, as a bondholder you get paid before shareholders.

There's no such safety with shares. As a shareholder, you are last in the queue to get paid. According to the financial textbooks, you should make more money for taking this extra risk (what's known as the equity risk premium), but the relative outperformance of bonds in recent years has shaken many investors' faith in this theory what may have been true in the past may not be so today.

Another temptation of bonds is that these days it's much easier for private investors to dabble in individual bonds, rather than buy a fund, by using the relatively new retail bond market platform.

That all sounds good, and it's great that this asset class has been opened up to private investors. But should you be buying more of these bonds for your portfolio right now? That's quite another question -and we wouldn't be too hasty.

As regular readers will know by now, when an asset class becomes wildly popular, it's a warning sign. And while there are some attractive opportunities in the market, there are plenty of pitfalls too. We'll get to those in a minute first let's look at how the retail bond market actually works.

The order book for retail bonds

Buying and selling shares is very straightforward for private investors. But until recently, buying the debt of firms corporate bonds was a different matter. This market was essentially the preserve of professional investors and wealthy private individuals, as most bonds traded in units of £50,000 a piece.

Things are much better now. In February 2010, the London Stock Exchange (LSE) set up an electronic order book for retail bonds, great for do-it-yourself investors who want to manage their own money. Gone are the days of having to deal in units of £50,000.

Most retail corporate bonds can be bought in typical unit sizes of £1,000, and traded in amounts as low as £100. There are now just over 100 retail corporate bonds to buy, meaning there is a decent alternative to buying a corporate bond fund, and paying the charges that go with it.

But it's one thing to be able to trade these bonds whether they are good investments is quite another matter. So what should you watch out for?

A good deal for firms

Returns on savings accounts are poor, with even the best only just beating inflation. So you can see why income-producing investments (even though they are much riskier than any bank account) have boomed in popularity, as yield-hungry investors pile in.

The retail bond market has been a major beneficiary of this move. Since March 2011, nearly £1.8bn has been raised by companies in this market. But who is getting the best deal? Investors? Or canny companies who get to raise money cheaply at a time when interest rates are at rock-bottom levels?

For companies, in most cases, debt finance (bonds) is cheaper than equity finance (shares). There are two main reasons for this. The first boils down to the fact that debt is less risky for the holder. Bondholders get paid before shareholders, so they will usually accept lower returns for this relative safety.

The second reason is tax. Interest payments on bonds and other borrowings can be used to reduce a company's tax bill. Dividend payments can't. So with the UK corporation tax rate at 24%, a bond paying 5% annual interest actually costs a company 3.8% (5% x (1-0.24)). So you can see why companies prefer to finance themselves with debt if they can.

What is 'clean' and 'dirty' pricing?

Bonds are said to be "quoted clean but traded dirty". This refers to the fact there are two prices for a bond, the clean price, which excludes accrued interest, and the dirty price, which includes it. Accrued interest arises because bonds pay a coupon to the holder of the bond on set coupon dates.

Let's say a bond pays a semi-annual coupon of £100 on 1 June and 1 December. The bond's owner gets 100% of it on those dates. But what if they bought the bond on 28 May? Clearly, the seller will want them to pay a dirty price that includes most of the £100 coupon accrued up until 28 May.

Why not just quote the bond's daily dirty price in, say, the FT? Mainly because the clean price, excluding any accrued interest, is needed for important yield calculations.

Retail bonds offer two other advantages for companies. Firstly, it allows them to raise relatively small amounts of money: from £25m to £250m. Secondly, unlike in the larger wholesale bond market where issue sizes are greater than £250m the bonds do not have to have a credit rating.

This means that the interest rate paid on the bond is slightly higher than it would be on the wholesale market, but the company avoids the costs associated with a credit rating.

The retail bond market has also opened up a reliable source of financing for certain types of company. For example, property companies such as CLS Holdings, Primary Health Properties and Workspace may have found it hard to get financing at good interest rates from currently risk-averse banks. The retail bond market has therefore been very useful for them.

Are investors getting a good deal?

But what about investors in the market? Compared to the tiny rates of interest on savings accounts, some of the income yields on offer from retail bonds look quite respectable. But are they good enough to compensate you for the risks you are taking? There are several questions you need to ask yourself before you decide.

Firstly, what type of business are you investing in? It's easy to forget this basic question and just look at a bond as if it were a savings account. It's nothing of the sort your capital is at risk, just as if you bought a share, and you aren't covered by the Financial Services Compensation Scheme (FSCS) if the bondholder can't pay up.

So there's a big difference between the safety of a bond issued by a water firm or a supermarket where the cash coming into the business is fairly stable and predictable and that of an insurance, bank or property company, where profits can move up and down a lot, and debts are often high.

A few basic calculations, using data from the company's annual report, will give you a good idea of the safety of a bond.

You should calculate the firm's ability to pay its interest bill its interest cover'. This is simply operating profit divided by interest payable it shows how many times the firm's profits would have paid its interest bill. A low number may be a warning sign that your bond interest might not be paid if the firm's profits fall.

Also check how much equity financing there is in a business. A bank manager will insist on you putting up a sizeable equity stake (ie, a deposit) before giving you a mortgage. That's because if the price of the house drops, you are the one who takes the hit first.

Similarly, you should be keen to see the same thing before buying a retail bond. So look at the ratio of debt to shareholders' funds (equity) and equity to total assets. (A number above 100% indicates there is more debt than equity funding.)

As you can see from the table below, the property companies we mentioned earlier have lots of debt and low levels of interest cover. Are you really getting a big enough income from their bonds, given the risks you are taking on? Severn Trent and National Grid are in a similar camp, but arguably have more secure income streams to pay their interest bills.

'Clean' prices as of 2 October 2012. Note you will usually have to pay accrued interest on top of these prices ('dirty' prices)

You should also consider the bond's maturity date that's when the company is due to repay your capital. Before the credit crunch, it was taken for granted by many that companies could just borrow more money to pay you back usually by rolling over' the debt, ie, issuing another bond. That might not always be possible to do if markets are panicky. So check that the bond issuer generates plenty of surplus cash, or that it can sell assets to raise money if times get really tough.

If you are satisfied that the retail bond is backed by a sound business, then you need to take into account a couple of other things. Your interest payment will be fixed for as long as you hold the bond. You will not participate in any growth of the company's profits and in most cases you will not be protected from rising inflation. Also bear in mind that you may lose money if you pay more than the par value of the bond (usually £100) and sell before the maturity date.

Also, interest from bonds is paid gross or before tax is taken away. Unless you hold your bond in an Individual Savings Account (which you can only do if the maturity date is five years or more away) or a Self-Invested Personal Pension (Sipp), you will be liable for income tax on the coupons.

The biggest threat

There's one other major risk that we haven't touched on yet: higher interest rates. Rising rates are the enemy of all bond investors. When they go up, bond prices have to go down in order to attract buyers why would you put money in a bond paying 5% if you could get a bank account paying 6%?

At the moment, many people think that interest rates simply can't go up. They think that the Bank of England can keep rigging the market. But this is wishful thinking over the long run. There's only so long the Bank can keep creating money out of fresh air before either the bond market or the currency market says "enough is enough". And when interest rates do move, they could move quickly.

If and when this happens, shares will get hammered too, but fixed income investments like bonds will look very unattractive indeed, particularly given how expensive they are just now.

So if you're thinking of buying retail bonds, be careful. While we like the fact that this market has been opened up to private investors, in the current environment it's mainly the firms who are getting the best deal, rather than the people lending them money. We look at some of the more attractive options below.

Should you buy the shares or the bonds?

If you are looking for income, it's worth comparing the yield on a company's retail bond with the dividend yield on its shares. In some cases, you might be better with the shares. Have a look at the tablebelow.

Prices as of 2 October 2012

Where the bond yield is much bigger than the dividend yield, it makes sense to own the bond. You are getting paid first and you are getting paid more. The chances are the dividend on the shares won't grow fast enough to give you a higher income over time. On that basis, you might buy the retail bonds of Intermediate Capital, Provident Financial and Beazley.

But if you look at the index-linked bonds of Severn Trent and National Grid this is probably not the case. With inflation currently subdued, the income from the shares looks a better investment. Regulatory reviews aside, income and dividends should grow in line with inflation. So the shares might actually end up being a better index-linked income stream than the bonds.

Despite its woes, we also think that Tesco may still be able to grow its dividend it's well covered by profits, which suggests it could pay bigger dividends, so you might get more income from owning the shares.

Another option is to look at older bond issues. The income available from most newly issued retail bonds is hardly generous. The same can be said for the vast majority of retail bonds already trading. Like high dividend, blue-chip shares, they are being buoyed by desperate investors scrambling for yield.

So if you actually want to get high levels of income from retail corporate bonds, you'll have to take some big risks. Several bank bonds pay chunky yields, but they are backed by highly indebted businesses. This means there's a reasonable chance that you might not get all your money back.

An interesting alternative is pub business Enterprise Inns. Its 6.5% bonds, due in 2018, currently trade below par at £88.25. It has an income yield of 7.4%. If you held the bond until 2018 and got £100 back as well, you would get a redemption yield of 9%, reflecting the capital gain. This looks good, but it's risky. Interest payments are only covered 1.8 times by profits, and it's possible the company might have to sell lots of pubs to pay the bondholders back. These bonds are a buy for the brave.