The crash has led to a new boom in corporate bonds. When Tesco’s debt yields more than its shares, every little helps
When the Bank of England began its £200 billion programme of quantitative easing — ‘QE’, its technical name for printing money — at the height of the credit crisis in March last year, it made two important discoveries.
The initial plan of the Bank’s markets director, Paul Fisher, was to use the money to buy up bonds issued by major companies. This, it was hoped, would put cash into company balance sheets and help prevent the crisis cascading though the rest of the economy. But the Bank quickly learned that, apart from a few blue-chip companies, the market in UK corporate bonds was virtually nonexistent. American companies have long been users of the bond markets, but the British have preferred to raise their new capital by creating and selling new shares. And, unlike the London markets in shares and gilts, the UK corporate bond market was far from perfect. It was something of a throwback to the days before the ‘Big Bang’ in 1986, when the City opened its door to all-comers in securities trading. Corporate bonds seemed to have been left behind, changing hands among a small group of market-makers who held little stock, which meant the price spread between buyers and sellers was dauntingly wide.
Fisher quickly concluded that if the Bank wanted to force-feed the money markets with cash — to make them more liquid — it would be quicker and more efficient to buy gilts. In the meantime, he would work with the corporate bond market in an effort to make it more transparent and efficient, so that it was better trusted by investors.
QE, together with the Bank’s negotiations with bond issuing houses, made a real difference. In the first instance, by buying up gilts from professional investors such as insurance companies, it gave them more liquidity. So when companies, including hard-pressed banks, returned to fundraising, the insurers had the cash to meet the challenge. Firms raising cash had the choice between a traditional rights issue of shares, often long-winded and destabilising, or going for long-term debt in the form of a corporate bond. Both routes enabled them to improve their balance sheets. The choice also meant that, despite the shortage of conventional credit from banks and one or two high-profile bankruptcies early on, there were remarkably few large-scale corporate insolvencies.
When major UK companies now want to raise capital for expansion, the bond market is a real option. In recent weeks BP, having capped the Macondo well in the Gulf of Mexico and shrugged off some of the political fall-out, chose to do its first post-disaster fundraising in the bond market, raising $3.25 billion. This was a larger sum than expected, and meant that BP did not have to raise equity at the deeply discounted price to which its shares had plunged, while demonstrating to a broader audience that it was back in business.
In a different context, Tesco, which is engaged in a massive expansion programme at home and overseas, did most of its fundraising in 2009/10 in the sterling bond market. Professional investors proved to have a healthy appetite for Tesco bonds because of the company’s strong cash flow, good asset backing (through property) and growth record. What has made Tesco bonds and those of other well-known corporations even more attractive is that they are now also accessible to retail investors too.
When the London Stock Exchange (LSE) merged with Borsa Italiana, it also acquired MOT, the largest and most accessible retail bond trading platform in Europe. So it is now possible for retail investors to buy corporate bonds direct from their stockbroker through the LSE in such household names as GlaxoSmithKline, Barclays and Enterprise Inns as well as Tesco — rather than the second-best option of buying into a bond fund. A number of London broking firms, including Evolution, Shore Capital and Killik & Co, offer retail bond trading.
So what’s the attraction of bonds against shares? Over much of the last year there has been no contest. Not only have corporate bonds offered better yields, they have also rallied strongly while equity markets (until the last month) have been in the doldrums.
Oddly enough, markets currently find themselves in a different place. Because bonds are regarded as riskier than shares, they normally offer a higher (and inflation-beating) coupon. However, all that has been changed by a huge rally in corporate bonds. In Britain, Germany and Japan, they now offer lower yields than equities. This is known to the cognoscenti as a ‘reverse yield gap’, and it might suggest that shares offer better value for investors than bonds.
But anyone turning to the stock market for yield has to be aware of the downside. Whereas the new BP bond issue offers an interest-rate coupon of 2.15 per cent above a US Treasury benchmark, BP shares currently offer no coupon because the dividend (not so long ago among the best in the FTSE) was axed under political pressure at the height of the Gulf of Mexico spill.
Yields on bonds are a relative certainty, whereas those on equities are more exposed to the ups and downs of the stock market. Investors looking for exposure to retail would be better to invest in Tesco bonds with a yield in excess of 4 per cent — a far better return than the company’s shares. Similarly, a new Barclays bond directed at private investors offers an inflation-adjusted coupon with a minimum return of 3 per cent, which is a more certain yield than the bank’s shares.
The safety of bonds is largely judged by credit rating agencies. Blue-chip companies like Barclays and Tesco normally attract the best ratings, but the returns are more limited, while weaker names with unrated or ‘junk’ bonds offer the highest returns. The best bond fund managers seek to provide balanced portfolios with a blend of highly rated and junk bonds. That is why so many investors still prefer funds managed by professionals, rather than direct involvement.
But the LSE’s new bond trading service offers an alternate approach. More than €230 billion of bonds are traded on the MOT platform in Italy, demonstrating the scope for corporate bond investment. In the UK we are at the start of a learning curve. As a result of actions by the Bank of England and the LSE, markets have become more liquid, transparent and accessible. Corporate bonds offer an attractive alternative to shares and their yields, even for the most blue-chip companies, trump those for sovereign debt.
This may not be the best moment to become a bull of corporate bonds, after a year-long rally. But at time when income is hard to come by, they are a far more attractive option than gilts, or simply leaving your cash on deposit.
Alex Brummer is City editor of the Daily Mail.