Corporate bonds may be the right medicine for investors
Offer of high interest reflects new promise in sector
Naomi Rovnick 5 April 2009
What is the likelihood of Pfizer, the world’s largest drug company, going bust? Probably very small, unless a miracle stopped the entire world’s population from getting ill again.
Earlier this month, Pfizer sold bonds worth a combined US$13.5 million, offering an average interest of 5.25 per cent. Pfizer and other healthy companies have not coughed up so much for their cash since the Great Depression, according to Investec Asset Management’s John Stopford.
Banks are turning lending business away as they rebuild their balance sheets and continue choking on toxic debt. This is bad news for companies that wish to borrow from banks. But it is possibly excellent for private investors, who can now lend to the world’s best businesses at excellent interest rates through the bond markets.
Bonds are a way for companies to borrow money as an alternative to bank loans - they are a form of IOU. The bond issuer asks its lenders for money and promises to pay interest for a fixed period of anything from three months to 30 years. The way professional investors tell if a corporate bond is good value is to compare its yield (its annual interest payments as a proportion of its current price) to the yield on US government bonds. Right now, the yield on 10-year Treasury bonds is 2.69 per cent. Pfizer is paying almost double that.
This is a huge change from just two years ago. In the great global loan bonanza of 2004-07 - when banks lent cheaply and indiscriminately before slicing and dicing the debt and selling it on for a fee - they offered companies very cheap money. During that period, healthy investment-grade companies also paid skinny interest rates on their bonds, about 1 per cent above US government debt. But since the credit crisis and global recession, everything has changed.
“The market is predicting 40 per cent of companies will default over the next five years,” Mr. Stopford said. “In the last 80 years, the highest level of defaults in a five-year period was 10 per cent.”
Risky firms selling the so-called sub-investment-grade bonds - which means ratings agencies believe they could struggle to repay the loans - are currently paying as much as 18 per cent.
Individual corporate bonds generally require US$100,000 of minimum investment. Carman Wong of ABN Amro suggests people with US$5 million to HK$10 million to invest could afford corporate bonds from 10 to 20 companies as part of a sensible asset allocation strategy.
For the rest of us, there are bond funds. These are baskets of 100 to 200 different companies’ bonds selected by professional managers. The interest payments from all the bonds are collected into the fund. Investors receive their share of these dividends.
HSBC’s local head of wealth management, Bruno Lee, suggests five such funds suitable for conservative retail investors and which have track records of good performance (pictured). But investors should talk to their own advisers to find out which funds are best suited for them.
There are also exchange-traded funds (ETFs), which are bought and sold like shares and trade on stock exchanges, offering corporate bond exposure. ETFs are cheaper than managed funds but they do not have professional managers selecting which bonds to buy and sell. Barclays iShares, for example, offers an ETF listed in London which tracks bond prices in the iBoxx Liquid Investment Grade Top 30 index.
Of course, there are pros and cons to investing in corporate bonds. As you will see from the chart, not one of the funds highlighted here finished in the black last year. Corporate bonds are only as good as the company borrowing the money. Many businesses lost money last year, so corporate bond prices fell along with the shares.
To value corporate bonds, investors must look at yield, not price. When traders buy these bonds, they compare the income yield to that offered by low-risk US government bonds. When a company is considered risky, investors want the yield to rise as compensation for the danger of the business going bankrupt.
Traders, of course, cannot demand that a company pay higher interest on its bonds. Instead, they pay less for the bonds themselves - which has the effect of making their interest yield rise.
Bonds do not have a real price. Every bond has a launch value of a nominal 100, though you cannot buy a bond for 100 Hong Kong dollars, US dollars or euros. This 100 of so-called par value determines the price.
A US$100,000 investment in an individual bond would have a par value of 100. If the bond’s price fell 30 per cent, the par value would show on the trading screen as 70 and the investment would be worth US$70,000.
Beleaguered Ford Motors provides a good example. In October 2006, the car giant’s subsidiary Ford Motor Credit, which raises money in the bond markets to provide car buyers with loans, launched a five-year bond paying 9.9 per cent annual interest, therefore offering a 9.9 per cent yield. The bond’s par value has now fallen to 75.5.
Investors are demanding a higher interest rate from the Ford Credit bond. The bond now pays a 13.1 per cent interest yield because, while the interest payment remains the same, traders are only paying 75.5 for the bond (9.9/13.1) x 100 = 75.5.
Investors need to know this simple maths because they have to compare bond yields both in respect to the yield on risk-free US government bonds and to interest rates.
The yield on US Treasuries, and any other central government bond, tends to be just a little higher than central bank interest rates.
The US government has cranked up the printing presses to flood its sickly economy with new money. Some economists believe this could cause hyperinflation, leading the Federal Reserve to raise interest rates. This would make corporate bonds a bad investment.
Another thing investors must be wary of is more companies going bankrupt, or facing that risk. Credit ratings agencies Moody’s and Standard & Poor’s have huge influence over the price of bonds. These agencies have teams of inspectors who pore over companies’ accounts and grade their performance, with AAA ratings for the healthiest companies to D for businesses close to defaulting on their debt payments.
Any company with a BB+ mark or below from S&P or Ba1 from Moody’s is considered below investment grade, so their bonds tend to be low-valued. Moody’s last month predicted 15 per cent of the companies with bonds rated below investment grade could default on their interest payments in this year.
Bond traders punish companies who get downgraded by the ratings agencies, demanding higher yields, so their bond prices plunge. If downgrades were to become very widespread, as some advisers fear, bond investors would suffer losses.
“Although there are some good corporate bonds out there, investors should be highly cautious,” said Paul Ramscar, head of private client services at the Hong Kong independent financial adviser Tyche Group.
“Undoubtedly, some of the largest corporates have assets on their books which are experiencing dramatic drops in prices, such as commercial real estate. This will impact bond prices and returns to investors.”
Investec’s Mr. Stopford, however, argues this is more than priced in. He believes investors have become so worried about companies going bankrupt that bonds are trading at irrationally pessimistic levels.
Ms. Wong also expects bond prices to recover instead of falling further. She believes that if this financial crisis is anything like the Great Depression of the 1930s, corporate bonds could turn out to be an excellent investment over the next few years. “Between 1931 and 1936, corporate bond returns were around 20 per cent a year, with bond prices rising as markets and economies recovered,” Ms. Wong said. Bond funds must be selected with extreme care, however. Investors can find fund fact sheets on the website of fund information provider Morningstar.
Lionel Kwok, the head of investment solutions for North Asia at Credit Suisse Private Bank, is concerned about inflation and rising interest rates. But with a global recession, this is not likely in the next two to three years.
He suggests investors look at individual bonds with less than a five-year duration.
Investors should also seek out funds that invest in the most defensive, or recession-proof, companies. These are normally firms providing life’s basics, such as water, electricity, pharmaceuticals and telecommunications.
What you need to know
Bond
Like an IOU. Investors lend money to a company for a fixed period of anywhere between five and 25 years. The bond borrower pays its lenders interest and repays the money at the end of the term. Lenders are usually pension funds, wealthy individuals and bond fund managers. The minimum investment is often US$100,000.
Yield
The interest a company pays every year divided by the value of its bonds. Bonds always launch priced at a nominal 100. In the secondary market, yields rise when prices fall and yields fall when prices rise.
Treasury yield
The interest paid by a 10-year US government bond as a proportion of its price. This is currently around 2.7 per cent. With corporate bonds, investors like yields to be higher than Treasuries because businesses go bust while governments generally don’t.
Corporate bond fund
For people not rich enough to buy individual bonds. Usually portfolios of 100-200 corporate bonds, managed by institutions. Retail investors buy small stakes in the funds. Bond funds collect all the interest payments from the bonds they hold and pay investors their share of this interest each month. A good choice for people who want a regular monthly income from an investment.
Spread
The gap between the interest payment, or yield, between US government bonds and corporate bonds.
If a 10-year US government bond offers an interest yield of 3 per cent and a corporate bond’s yield is 8 per cent, the spread is 5 per cent.
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Corporate bonds may be the right medicine for investors
Offer of high interest reflects new promise in sector
Naomi Rovnick
5 April 2009
What is the likelihood of Pfizer, the world’s largest drug company, going bust? Probably very small, unless a miracle stopped the entire world’s population from getting ill again.
Earlier this month, Pfizer sold bonds worth a combined US$13.5 million, offering an average interest of 5.25 per cent. Pfizer and other healthy companies have not coughed up so much for their cash since the Great Depression, according to Investec Asset Management’s John Stopford.
Banks are turning lending business away as they rebuild their balance sheets and continue choking on toxic debt. This is bad news for companies that wish to borrow from banks. But it is possibly excellent for private investors, who can now lend to the world’s best businesses at excellent interest rates through the bond markets.
Bonds are a way for companies to borrow money as an alternative to bank loans - they are a form of IOU. The bond issuer asks its lenders for money and promises to pay interest for a fixed period of anything from three months to 30 years. The way professional investors tell if a corporate bond is good value is to compare its yield (its annual interest payments as a proportion of its current price) to the yield on US government bonds. Right now, the yield on 10-year Treasury bonds is 2.69 per cent. Pfizer is paying almost double that.
This is a huge change from just two years ago. In the great global loan bonanza of 2004-07 - when banks lent cheaply and indiscriminately before slicing and dicing the debt and selling it on for a fee - they offered companies very cheap money. During that period, healthy investment-grade companies also paid skinny interest rates on their bonds, about 1 per cent above US government debt. But since the credit crisis and global recession, everything has changed.
“The market is predicting 40 per cent of companies will default over the next five years,” Mr. Stopford said. “In the last 80 years, the highest level of defaults in a five-year period was 10 per cent.”
Risky firms selling the so-called sub-investment-grade bonds - which means ratings agencies believe they could struggle to repay the loans - are currently paying as much as 18 per cent.
Individual corporate bonds generally require US$100,000 of minimum investment. Carman Wong of ABN Amro suggests people with US$5 million to HK$10 million to invest could afford corporate bonds from 10 to 20 companies as part of a sensible asset allocation strategy.
For the rest of us, there are bond funds. These are baskets of 100 to 200 different companies’ bonds selected by professional managers. The interest payments from all the bonds are collected into the fund. Investors receive their share of these dividends.
HSBC’s local head of wealth management, Bruno Lee, suggests five such funds suitable for conservative retail investors and which have track records of good performance (pictured). But investors should talk to their own advisers to find out which funds are best suited for them.
There are also exchange-traded funds (ETFs), which are bought and sold like shares and trade on stock exchanges, offering corporate bond exposure. ETFs are cheaper than managed funds but they do not have professional managers selecting which bonds to buy and sell. Barclays iShares, for example, offers an ETF listed in London which tracks bond prices in the iBoxx Liquid Investment Grade Top 30 index.
Of course, there are pros and cons to investing in corporate bonds. As you will see from the chart, not one of the funds highlighted here finished in the black last year. Corporate bonds are only as good as the company borrowing the money. Many businesses lost money last year, so corporate bond prices fell along with the shares.
To value corporate bonds, investors must look at yield, not price. When traders buy these bonds, they compare the income yield to that offered by low-risk US government bonds. When a company is considered risky, investors want the yield to rise as compensation for the danger of the business going bankrupt.
Traders, of course, cannot demand that a company pay higher interest on its bonds. Instead, they pay less for the bonds themselves - which has the effect of making their interest yield rise.
Bonds do not have a real price. Every bond has a launch value of a nominal 100, though you cannot buy a bond for 100 Hong Kong dollars, US dollars or euros. This 100 of so-called par value determines the price.
A US$100,000 investment in an individual bond would have a par value of 100. If the bond’s price fell 30 per cent, the par value would show on the trading screen as 70 and the investment would be worth US$70,000.
Beleaguered Ford Motors provides a good example. In October 2006, the car giant’s subsidiary Ford Motor Credit, which raises money in the bond markets to provide car buyers with loans, launched a five-year bond paying 9.9 per cent annual interest, therefore offering a 9.9 per cent yield. The bond’s par value has now fallen to 75.5.
Investors are demanding a higher interest rate from the Ford Credit bond. The bond now pays a 13.1 per cent interest yield because, while the interest payment remains the same, traders are only paying 75.5 for the bond (9.9/13.1) x 100 = 75.5.
Investors need to know this simple maths because they have to compare bond yields both in respect to the yield on risk-free US government bonds and to interest rates.
The yield on US Treasuries, and any other central government bond, tends to be just a little higher than central bank interest rates.
The US government has cranked up the printing presses to flood its sickly economy with new money. Some economists believe this could cause hyperinflation, leading the Federal Reserve to raise interest rates. This would make corporate bonds a bad investment.
Another thing investors must be wary of is more companies going bankrupt, or facing that risk. Credit ratings agencies Moody’s and Standard & Poor’s have huge influence over the price of bonds. These agencies have teams of inspectors who pore over companies’ accounts and grade their performance, with AAA ratings for the healthiest companies to D for businesses close to defaulting on their debt payments.
Any company with a BB+ mark or below from S&P or Ba1 from Moody’s is considered below investment grade, so their bonds tend to be low-valued. Moody’s last month predicted 15 per cent of the companies with bonds rated below investment grade could default on their interest payments in this year.
Bond traders punish companies who get downgraded by the ratings agencies, demanding higher yields, so their bond prices plunge. If downgrades were to become very widespread, as some advisers fear, bond investors would suffer losses.
“Although there are some good corporate bonds out there, investors should be highly cautious,” said Paul Ramscar, head of private client services at the Hong Kong independent financial adviser Tyche Group.
“Undoubtedly, some of the largest corporates have assets on their books which are experiencing dramatic drops in prices, such as commercial real estate. This will impact bond prices and returns to investors.”
Investec’s Mr. Stopford, however, argues this is more than priced in. He believes investors have become so worried about companies going bankrupt that bonds are trading at irrationally pessimistic levels.
Ms. Wong also expects bond prices to recover instead of falling further. She believes that if this financial crisis is anything like the Great Depression of the 1930s, corporate bonds could turn out to be an excellent investment over the next few years. “Between 1931 and 1936, corporate bond returns were around 20 per cent a year, with bond prices rising as markets and economies recovered,” Ms. Wong said. Bond funds must be selected with extreme care, however. Investors can find fund fact sheets on the website of fund information provider Morningstar.
Lionel Kwok, the head of investment solutions for North Asia at Credit Suisse Private Bank, is concerned about inflation and rising interest rates. But with a global recession, this is not likely in the next two to three years.
He suggests investors look at individual bonds with less than a five-year duration.
Investors should also seek out funds that invest in the most defensive, or recession-proof, companies. These are normally firms providing life’s basics, such as water, electricity, pharmaceuticals and telecommunications.
What you need to know
Bond
Like an IOU. Investors lend money to a company for a fixed period of anywhere between five and 25 years. The bond borrower pays its lenders interest and repays the money at the end of the term. Lenders are usually pension funds, wealthy individuals and bond fund managers. The minimum investment is often US$100,000.
Yield
The interest a company pays every year divided by the value of its bonds. Bonds always launch priced at a nominal 100. In the secondary market, yields rise when prices fall and yields fall when prices rise.
Treasury yield
The interest paid by a 10-year US government bond as a proportion of its price. This is currently around 2.7 per cent. With corporate bonds, investors like yields to be higher than Treasuries because businesses go bust while governments generally don’t.
Corporate bond fund
For people not rich enough to buy individual bonds. Usually portfolios of 100-200 corporate bonds, managed by institutions. Retail investors buy small stakes in the funds. Bond funds collect all the interest payments from the bonds they hold and pay investors their share of this interest each month. A good choice for people who want a regular monthly income from an investment.
Spread
The gap between the interest payment, or yield, between US government bonds and corporate bonds.
If a 10-year US government bond offers an interest yield of 3 per cent and a corporate bond’s yield is 8 per cent, the spread is 5 per cent.
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