Investing in bonds. What is a bond? Why do companies issue them?

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1 Investing in bonds Investing in bonds is now much easier for private investors thanks to the launch in 2010 of the London Stock Exchange's retail bond market (ORB). A by-product of the credit crunch is that cashstarved companies and yield hungry investors have helped create a new market for non-bank finance and bond issuance has picked up as smaller- and medium-sized companies diversify their funding requirements. As with any novel investment, the need to understand the basics of what is on offer is more important than ever, particularly as corporate bonds are often confused with term-limited cash savings accounts which often go by the same name. Hopefully, this guide will give you enough tips on the basics of trading in bonds to build a durable portfolio and avoid some of the pitfalls of an asset class which hasn't featured much in the UK investment landscape for some decades. What is a bond? Why do companies issue them? A bond is the issued debt of a governments or companies which can be openly traded on the market. It offers a promise to pay a fixed level of annual interest via a set coupon and, if held to maturity, investors are returned 100 per cent of their capital. Bonds are used by investors as a stable source of income and to balance off the volatility risk of shares within a portfolio. Many professional investors will do nothing other than trade bonds, with varying levels of credit quality and sensitivity to interest rates and inflation opening up interesting trading opportunities. Companies like to issue bonds because they allow longer repayment times than are usual with bank debt. This helps with capital planning and means large amounts of money can be raised for basic funding without diluting existing shareholders. Interest (coupon) payments are also tax deductible. Why are bonds popular? The basic reality is corporate bonds have rapidly become an important source of income for investors who have been battered by low interest rates, with their consequent impact on cash deposit accounts and annuity rates. Bonds offer stable income and a guaranteed return of all your capital as long as the issuer remains solvent. At the same time, the stock market has proved to be a miserable store of value with share prices stuck in a decade-long trading range punctuated by a series of crashes. In such circumstances, investors cannot be blamed for finding alternatives. The other structural factor is the credit squeeze imposed by the banks in the wake of the credit crunch is forcing smaller- and medium-sized companies to seek alternative sources of funding. The squeeze takes the form of higher arrangement fees for loans, larger charges of not using arranged banking facilities and more stringent debt covenants. The spread over gilts for bank debt has widened considerably, meaning banks are earning well in excess of their cost of funding. The other common complaint is that banks will not generally lend longer than four or five years, whereas retail bonds last two or three years longer on average.

2 Accessing the market has become a lot easier in the past year or so, particularly now that execution only brokers are able to source bonds as standard, although you may have to ring up and place the order. The main market-makers and order-takers are Killik & Co, Collins Stewart and Investec. Price updates are available on the London Stock Exchange's website but Investec is helping to put together a "live" index of retail bond prices which should give investors an over-view of which direction the retail market is headed. Part 1: What are the risks There are three main risks with bond buying, only one relates to the quality of the bond. Macroeconomic factors such as inflation and changes in interest rates will affect the value of bonds during their lifetime. If inflation and/or interest rates rise, then bond yields tend to fall. Conversely, a low interest rate/inflation environment such as we have at the moment will squeeze yields as investors bid up prices. The specific risk to a bond is the underlying solvency of the issuer. This can affect all bonds but is more of an issue in the high-yield junk bond market where a careful appraisal of a company's financial position is definitely needed. Also, unlike cash deposit accounts, which are confusingly also called "bonds" by some high street lenders, corporate bonds are not covered by the asset protection scheme, so investors should be particularly aware of "downside risk", basically the factors that could stop a bond being redeemed. Advantages of bonds over shares The main advantage over shares is stable capital value over a fixed period of time. As long as the entity issuing the bond stays solvent you will get your money back. Shares are inherently unstable by comparison, with average values almost unchanged over the past 10 years, which masks steep declines in certain sectors. Can you tell if bonds are good value? After the crash in 2008, many bonds issued by rock-solid companies ended up trading far below par, offering investors the once-in-a-generation opportunity of significant capital appreciation on top of massive income yields. Apart from this exceptional event, identifying mispriced bonds with a single proven formula is difficult when the returns on the asset are determined well in advance. Corporate bonds tend to look good value when other assets are either over-valued (like share prices in 2007) or if a sudden dash for safety pushes up the value of safe-haven assets such as US Treasuries, Bunds, or Gilts. Currently, the yields on government debt have reached record lows - yields on ten-year gilts have fallen from 4 per cent in 2009 to just 1.5 per cent now (2012). This is due in no small part to the fact that central banks have become the biggest buyers of government paper through money printing. In this scenario, the 3 percentage yield over gilts that most high-grade corporate bonds attract looks good value. However, new issues will start to reflect the low interest rate environment as corporate bonds track the gilt market. In this scenario, bonds with payouts linked to inflation start to appreciate in value and, in fact, inflation-linked bonds have been one of the best performing asset classes over the past two years.

3 Part 2: Building a model portfolio Now let's consider how to pick bonds and organise a stable portfolio. Portfolio theory for fixed income is slightly different from equities as there is little need to match or exceed the returns made by the rest of the market. Bond returns are measured in advance if they are bought at par, however, a bondholder will need to smooth out the fluctuations in capital which can occur when bonds move towards maturity. That is where the "bond ladder" method of organising a portfolio comes into its own. How to construct a ladder portfolio: Rungs - Determining the duration of a bond portfolio involves dividing your available capital by the maximum number of years you wish to hold the bonds i.e. 100,000/10 years = 10 bonds of 10,000 each. Carefully planning the redemption dates means each year 10 per cent of your holding could in theory come up for renewal. The advantage of this system is that it smoothes out the interest rate risk over the lifetime of the portfolio by taking advantage of any potential change in rates. In the UK, for instance, interest rates can only rise from current levels in the medium term, so making the ladder longer will boost your returns as interest rates rise and yields increase. Bonds in your portfolio will be useful as you approach retirement. There is no hard and fast rule about how great a proportion of your portfolio should be made up of bonds. The most commonly quoted rule is that after 50 years old, the proportion should be upped by one percentage point a year until retirement in order to guarantee a stable income without risking the volatility of shares. In theory, that could mean 65 per cent of your liquid assets will be bonds. Part 3: Understanding the basic terms Accrued interest - Interest earned by the seller of a bond when it is sold before its redemption date. Bearer bonds - The money launderer's investment of choice before the US government cracked down on them in the early 1980s. Callable bonds - Often a feature of permanent interest bearing shares (PIBS), rather than corporate bonds, the issuer can recall the bond on a mandatory basis. Call date - When a bond is due to be redeemed. Coupon - The annual, or semi-annual, interest payment expressed as a percentage of a bonds nominal 100p value. Covenants - An indication of the level of legal protection bondholders receive if a company goes bust. Senior debt means holders are higher up the creditor pyramid and covenants will be stronger than subordinated debt. Credit-rating - Designations used by ratings services to give relative indications of credit quality, usually a ranging between AAA and BBB-. Double-barrelled bond - A bond is said to be "double-barrelled" when it is secured by the pledge of two or more sources of payment.

4 Downside risk - The possibility that a bond s rating will be lowered because of an issuer's worsening financial condition. Gilts - UK government debt, so-called because of the gilt edging that was used to frame the old bond certificates. High yield - Debt with either no credit rating or thought to be junk. Investment grade - This is debt issued by blue chip companies with a credit-rating between AAA and BBB. Linkers - Corporate bonds with payouts linked to inflation. Examples include index-linked gilts, TIPS, and some types of corporate bonds. Par - Equal to 100p. PIBS - Permanent interest bearing shares (PIBS) share many characteristics of bonds but are junior debt instruments issued by financial institutions. They carry a higher risk of default but also bigger coupons. Piece - The minimum denominations in which bonds can be purchased. This is usually 1 for gilts and 100 for UK corporate bonds. TIPS - Treasury Inflation Protected Securities is the US equivalent of inflation-linked gilts. Unsecured bond - A bond not secured by collateral. Yield - The yield equals the coupon divided by the price of the bond. Yield curve - The relationship between yield and maturity among bonds of different maturities but of the same credit quality. Part 4: Understanding the tricky bits The hardest part of bond trading is calculating your return if you buy and sell bonds before the redemption date, particularly when it comes to working your accrued interest. This is particularly important for investors who are into "stagging," ie. rolling capital into each new issue accruing interest along the way, leading ultimately to a decent total return on the original capital investment if the bonds are traded before redemption. Anecdotal evidence suggests some investors have made returns of up to 24 per cent in 2012 using this method. This can be complicated so I've included a basic guide to calculating accrued interest: If a bond pays an annual coupon of 8 per cent, the bond holder will receive an interest payment of 80 each year for a 1,000 nominal holding in that bond. However, if the bond holder chooses to sell the bond halfway through the year, he will have accrued six months of interest ( 40) which will be received by the buyer of the bond who gets the full coupon amount of 80 at the end of the annual coupon period. To compensate for this at the time of settlement of the bond trade, the bond buyer pays the accrued interest by paying the "dirty" price.

5 If we assume that the bond trades at par, the "clean" price would be 100, so the dirty price, reflecting the 40 per 1,000 nominal, will therefore be 104. The formula to calculate the accrued interest per 100 is: Accrued interest = Actual days between previous coupon and sett. date x coupon Interest actual days in coupon period Our debt pyramid below illustrates how some types of debt are higher up the payment order. Part 5: Importance of the prospectus The prospectus is the document which sets out the entire case for the offering. It is a legal document and must include the basic features of the bond. Things to look out for in a prospectus: 1) Covenants: Understanding the covenants on a bond is important because it defines your legal protection and your place in the debt hierarchy. For example, a recent St Modwen bond was senior unsecured which meant bondholders were high up the pyramid for repayment but without a claim on the company's physical assets. 2) The coupon level and when it is paid: this is either annually or semi-annually.

6 3) Financial covenant: this relates to undertakings the company makes to manage its financial position in a certain way. St Modwen, for example, pledged to keep its net debt at 75 per cent of its net assets. 4) Negative pledge: This means a company won t create new bonds at better terms without including existing bond holders. 5) Redemption clauses: this allows a company to redeem bonds early in case of major changes in tax law, for example. Before investing in bonds remember the following check list: 1) Make sure your bonds are capital gains tax friendly. This should be clearly stated in the prospectus. 2) Compare the yield with what a company has already issued on the market. Sometimes subscribing to an issue at par is better than paying a premium for a bond with a bigger coupon in the secondary market. 3) Check the company s ability to pay. The income sheet doesn t need to be stellar, just solidlooking. 4) Make sure you understand your place in the creditor pyramid. Being secured against assets is the best protection, but this is usually reserved for bank debts. 5) Be prepared to invest actively if inflation and interest-rate risks increase. Learn to space out redemption dates so you have reasonable access to funds. 6) Remember you ll always get at least your capital back, which is more than can be said for shares.