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Does opportunity knock in the UK retail bond market?

I have written quite a bit about corporate bonds on Monevator – but only because they looked unusually good value during the credit crisis, not because I particularly like the asset class.

Institutional investors were throwing everything overboard in late 2008 and early 2009 to stay afloat. As a result, higher quality ‘investment grade’ corporate bonds started looking too cheap compared to gilts and US treasuries, with the bond market seemingly pricing in unprecedented defaults in the wake of the collapse of Lehman Brothers in the US.

Since those dark days, corporate bonds have indeed posted positive capital returns. They’ve also delivered a decent income to those who bought at the lows and locked in attractive yields.

But as I suspected would be the case, equities (shares) have done even better!

Here’s the return from four iShares ETFs since the start of 2009:

Bonds have done well since the credit crisis, but equities better.

  • The FTSE 100 (Ticker: ISF) ETF is up 22.8%
  • The iShares £ Corporate Bond ETF (Ticker: SLXX) is up 9.0%
  • The iShares ex-Financials Bond ETF (Ticker: ISXF) is up 12.9%
  • The iShares Gilt ETF (Ticker: IGLT) is up 12.0%

These return figures flatter the FTSE 100 tracker, since they don’t include any income paid out by any of the ETFs over the years. But that won’t be enough to take the top spot away from the equity ETF.

Corporate coordination

So what do these relative returns tell us about investing in corporate bonds?

On the one hand, nothing much. It was just the way the cookie crumbled.

In another universe, where England won the European Cup, the sun actually shone in summer, and the Higgs Boson turned out to be a dead earwig stuck down the back of a CERN monitor, UK blue chip shares stayed mired around the 4,000-level for years, despite things calming down in the corporate bond market after the initial panic. In that scenario, the corporate bond ETF would have beaten the FTSE 100 tracker.

Indeed, the very strong returns from Gilts – theoretically the safest of all the asset classes here, which should imply lower rewards – underlines the dangers of drawing conclusions from three years of data, especially when the three years have been as weird as the ones we’ve just lived through.

On the other hand, my feeling is what we’ve seen from corporate bonds compared to equities is what’s usually to be expected. (Gilts are a different matter.)

Here’s why. Corporate bonds are linked to company health, just as equities are (although in very different ways, of course). This means that when equities sell-off in times of stress and panic, corporate bonds can do the same.

That’s different to the situation with government bonds such as gilts, which tend to be more negatively correlated with equities.

True, corporate bonds are much safer than equities, and also less volatile.

But at the same time, equities offer the expectation of much higher longer-term returns as compensation for those drawbacks. That has been hinted at over the past three years, and it’s visible in the historical returns.

Taking together, this explains why I generally favour getting exposure to companies from equities (at the price of far greater volatility than with corporate bonds) and to stick to using government bonds and/or cash for portfolio ballast.

Reasons to invest in corporate bonds

Still, some people like or need more income, and not only from equities. And with gilts and cash at record low yields, income seekers are leaving their comfort zones.

Investment grade corporate bonds currently yielding 2% to 3% or more over gilts certainly look a lot more attractive than the mere 1% spread over gilts they sported in the days before the credit crisis.

  • The best reasons for adding corporate bonds to your portfolio are extra diversification (with the caveats I’ve made above), and also a time horizon that means you don’t want to increase your equity holdings.
  • Bad reasons might include an irrational fear of the stock market, or if you are chasing a higher income regardless of fundamentals or valuations.
  • In between those two extremes of motivation would be the desire to dampen down the wildest lurches in your portfolio, while making a little bit more income.

The bottom line is that prudently investing in corporate bonds will probably deliver what you seek – clearly good – but on the downside it will probably also cost you in the long-term, with a lower total return than if you’d just added more equities and held tight.

The Order Book for Retail Bonds

There’s another reason for UK investors to look afresh at corporate bonds since the dark days of 2009, and that’s the subsequent launch of The Order Book for Retail Bonds (or ORB for short).

The London Stock Exchange introduced the ORB in 2010 to improve the accessibility of corporate bonds to ordinary Joes like us.

We could buy individual corporate bonds before the ORB, in theory. In practice, many UK retail brokers were on the wrong settlement system to enable the bulk of corporate bonds to be bought and sold by ordinary investors in our normal online accounts.

There were also very large minimum order sizes for some bonds – a mere bagatelle for a Mayfair fund manager, perhaps, but amounts that could alternatively buy a holiday cottage in the continent for most of us.

Liquidity could be poor, too.

Fast forward to now, and while it’s still relatively early days, the ORB seems to be delivering on improving access to corporate bonds, as well as making it easier to trade gilts.

When the ORB launched there were just ten corporate bonds and 49 gilts available on the service.

As of May, the LSE boasted:

“Continuous, transparent, two-way tradable prices in over 150 individual UK gilts, supranational and corporate bonds, all tradable in typical denominations of £1,000 or less.”

Along the way we’ve seen a string of new retail-targeted corporate bonds from the likes of Lloyds, Tesco, Provident Financial, and Severn Trent.

In May this year the ORB even announced a Renminbi-denominated retail bond from HSBC – the first non-Sterling bond open for on-exchange trading on its platform.

Most of the new retail bonds have sported flat coupons in the 5-5.5% range, though a few have offered higher yields. There have been a handful of inflation-linked issues, too.

Incidentally, a good place to keep tabs on retail bond launches is the Fixed Income Investor website, which has covered many of these bonds in its Bond of the Week articles.

Warning: Retail/corporate bonds are not the same as the ‘savings bonds’ from High Street banks. The latter are really fixed rate, fixed term savings accounts. True corporate bonds are not covered by the FSA, and you could conceivably lose all your money if the company issuing them goes bust.

One way to play the retail bond boom

Despite keeping an eye on the development of the ORB, my preference for equities means I’ve so far I’ve only invested in Tesco Personal Finance’s 5% issue in May, which will mature in 2020.

I might not hold it until then. This bond – like many other issues of the past year or so – is already trading at a slight premium, which leads me to a potentially cunning plan…

But allow me to first take a detour.

Currently I think shares look cheap compared to debt. I’d ideally like the LSE to enable private investors like me to issue millions in junk bonds just like the barbarian-styled corporate raiders of the 1980s. 🙂

I’d buy today’s blue chip shares with the proceeds, and pay the debt out of dividend yields. History, here I’d come!

Sadly that’s just a pipedream. We’re in the middle of a deleveraging crisis, and there’s no chance of me becoming the new Michael Milken.

However, my positive experience with Tesco Personal Finance – and a quick eyeballing of the price of other retail bonds issued so far – makes me wonder if another forgotten 1980s practice could be revived via the ORB market.

Readers of a certain age – I’m referring to ‘stagging’.

Stagging was the practice of subscribing to new share IPOs – typically the Thatcher-era privatisations of former state-owned industries – with no intention of holding any shares you were allocated.

Instead, you hoped to capitalize on the excessive demand for new issues by immediately selling your shares for a quick profit.

Three things made this attractive:

  • Firstly, new issues were often ‘priced to go’, so you could be pretty sure they’d trade at a profit when they hit the market.
  • Secondly, demand outweighed supply, adding to the potential for prices to rise on initial trading.
  • Finally, subscribing to a privatisation IPO was cheap and easy for the average person, compared to conventionally trading shares in the pre-Internet era.

Much of the above is also true of retail bonds today, albeit on a far smaller scale.

Market makers appear to be slightly under-pricing retail bonds compared to prices in the open market, even though the demand for income has never been greater. The process of subscribing through an online broker that’s supporting a new bond issue is easy, too, with no stamp duty to pay and my broker charging no dealing fees.1

Now, it’s important not to over-stretch the analogy with 1980s stagging.

My Tesco Personal Finance bonds are trading at a 4.75% premium, which isn’t bad after a couple of months, but it’s hardly the soaring returns that 1980s staggers enjoyed.

More importantly, we’re in an environment in which interest rates have been declining – yields on the ten-year gilt fell to fresh all-time lows in June. This alone could easily explain the rising prices of the retail bonds, rather than any pent-up demand.

My gut feel though is that there’s a quick trade to be had in these new issues, in the current climate (provided not many market makers read this article!)

Indeed, in my first draft of this article I explained how I would experimentally stag the new Primary Heath Properties (PHP) bond, which has solid property assets backing it, a relatively short maturity for a new bond, and pays a semi-annual coupon of 5.375%.

But the offer period has closed a week early, such has been the huge demand for this new bond!

I suspect this means we will indeed see PHP’s new bond trading higher when it goes on the open market, though sadly I’ve left it too late to profit.

Remember: This is not standard retail bond investing!

Let’s be clear – I am entertaining the idea of stagging new corporate bonds as a short-term opportunity, not suggesting that trading new issues will be a lynchpin in securing my long-term financial future.

Speculatively buying one or two corporate bonds is no way to diversify a portfolio, and I’d only put a tiny amount of my money into any new corporate bonds.

Finally, any investment would be made in my active trading portfolio, where it’s frequently in far more speculative securities than this!

As ever, please treat this article as educational, and not as financial advice. My feeling that retail bonds are being priced to deliver a premium is pure conjecture. Do your own research, and seek professional advice if you need it.

Want to know more? In part two I look at whether it’s practical or even desirable to build up your own corporate bond portfolio via the Order Book for Retail Bonds.

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  1. My broker for one is paid a distribution fee by the bond issuer, but this payment does not come directly from your investment nor affect your yield. []
{ 14 comments… add one }
  • 1 OldPro July 12, 2012, 3:28 pm

    Interesting… the boys from Fixed Income Investor have unearthed another one from interbroker ICAP… here’s the weblink: http://www.fixedincomeinvestor.co.uk/x/analysis.html?type=bond-blog&cat=analysis-comment

  • 2 gadgetmind July 12, 2012, 3:47 pm

    As it happens, ISXF and SLXX have been negatively correlated to equities over the last few years. Yes, I was also surprised, but someone on Motley Fool ran the numbers.

  • 3 The Investor July 12, 2012, 4:12 pm

    @gadgetmind — I would be surprised, but I wouldn’t disbelieve it. This bear-mania against a terrible backdrop has done all sorts of weird things to the fixed income market.

  • 4 gadgetmind July 12, 2012, 4:19 pm
  • 5 Neverland July 12, 2012, 4:52 pm

    Corporate bonds are actually mainstream private investments in italy, spain and germany

    Possibly more widely held than shares

    Its just an example of the UK becoming more European…

    plus of course financial repression forcing investors to take more risks in a search for yield

  • 6 gadgetmind July 12, 2012, 5:09 pm

    Bank preference shares are mainstream private investments in Spain and look how that’s going to play out!

    Lots of platforms including HL let you buy and sell corporate bonds so they are barely niche in the UK.

    My subordinated bank debt and underwater floating rate notes are a different kettle of fish!

  • 7 The Investor July 12, 2012, 7:32 pm

    @gadgetmind — Sure, but you are talking post ORB. 🙂 I don’t think there’s any doubt corporate bonds have now been made far more accessible for us private investing guys, especially for initial offerings and to a lesser extent for cheap online execution (though there are some issues, particularly around sector diversification, as I’ll discuss next week). Good luck with the exciting credit — I prefer to play that sort of thing via trusts etc. Thanks for the link — will read it ASAP. 🙂

    @Neverland — Indeed. Is it ‘the man from Belgium with his bonds’ they talk about? Or the man from Bonn… I don’t recall.

    @OldPro — Good spot, I’ll check it out. ICAP is a bit of a riskier affair then PHP though.

  • 8 The Investor July 12, 2012, 7:36 pm

    p.s. @gadgetmind — Read the thread. I’m surprised the negative correlation is that strong for corporates, but as I said in the article it has been a jolly weird period. Over longer periods I’d continue to expect at best mild negative correlation. They definitely aren’t gilt substitutes!

  • 9 gadgetmind July 12, 2012, 10:46 pm

    Yes, we live in interesting times for fixed interest. I’m diversifying with corporate bonds, using the blunderbuss of strategic bond funds, and also picking up some interesting prefs and PIBs.

    My latest quarry is INVR. Some credit risk but lots of capital and yield upside if/when interest rates kick up again. Meanwhile, 4%+ as a consolation prize unless Investec fold.

    Diversify, diversify, diversify!

  • 10 Financial Samurai July 13, 2012, 7:51 am

    Opportunity knocks everyday.

  • 11 gadgetmind July 13, 2012, 10:22 am

    @TI – “They definitely aren’t gilt substitutes!”

    Over the medium/long term, and under “normal” circumstances, I totally agree. But right now gilts just don’t have any yield and little chance of upside.

    The safe part of my portfolio is in corporate bonds, infrastructure and similar. As I look inside the portfolios of a lot of the managed funds, they seem to be thinking along similar lines. I’ve also taken the cop out route of strategic bonds, and those guys are also playing it very carefully with sovereign debt.

  • 12 The Investor July 13, 2012, 12:04 pm

    @gadgetmind — You pays yer money and takes yer choice. 🙂 I can totally see why you’d want to get the extra yield from corporate bonds, infrastructure etc, over gilts. I also don’t like gilts currently, and hold exactly zero.

    But don’t be under any illusions, whatever a managed fund or anyone else holds. Corporate bonds, infrastructure funds (invariably heavily geared) and the like are NOT the same as gilts. If we saw a 1930 style Great Depression, perhaps due to cataclysm in Europe, those assets would almost certainly fall far, far harder than gilts or cash. (The latter is my own preference as a gilt substitute currently, and it’s not the same as gilts either).

    Obviously it’s 100% your choice, these are just my thoughts. I’m relatively optimistic compared to most, and I think those investments will probably be fine (though as I say above in most cases I’d rather pure equities for exposure to companies). But they won’t be in a meltdown. No chance.

  • 13 gadgetmind July 13, 2012, 12:11 pm

    I’m optimistic because I have to be. There is no way to protect yourself from the kind of meltdown some predict other than by buying bullets and MREs.

    I have three years of essential spending held as cash and NS&I linkers, and the rest is in equities and bonds. If the latter all turns brown and smelly, the whole world will have worse problems that the state of my SIPP.

    That’s also why I’m buying some stuff that others find utterly unpalatable. Yes, total loss is possible, but there is a pleasantly asymmetric upside if everything muddles through, which it has done in the past.

  • 14 The Investor July 13, 2012, 12:15 pm

    There is no way to protect yourself from the kind of meltdown some predict other than by buying bullets and MREs.

    @Gadgetmind — Yes perhaps not the uber-bear meltdown scenario, but gilts and cash will help you plenty in a Japanese style stagnation. The baked beans and bullets is an Armageddon scenario. There’s a lot of outcomes in between a return to growth and a meltdown, whatever bearish bloggers who enjoy getting headlines but seem unable to read history books like to tell us.

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