Monday, 11 February 2013

The craziest bond investment?

Anyone who has ever borrowed money has worried about what would happen if something bad happened to them, and they had trouble repaying the loan. As a borrower, you run the risk that your home, your car and other assets could be at risk if you cannot make your payments. This is because there is a general rule that lenders’ interests rank ahead of borrowers’ interests when dealing with a troubled borrowers’ assets.

Life for borrowers would be much less stressful if you could find a lender who would agree in advance to forgive the loan if ever you got into a spot of bother. Unfortunately, this is not something you expect from a commercial lender. Until now.

In November 2012, Barclays Bank issued three billion dollars of contingent convertible bonds, known colloquially as CoCos. The CoCo bonds pay a modest 7.625% interest rate and are due for repayment in 2022. The sting for the bondholders is that if Barclays’ Tier One Capital Ratio (as defined by its UK regulator) ever falls below 7.0%, then the CoCo bonds will be cancelled, and no compensation will be paid to the bondholders.

Note that in this situation, the shareholders suffer no penalty, although of course it is probable that  losses that would cause Barclays capital ratio to fall from its current level of 11.2% to under 7%, would also cause a substantial reduction in the Barclays share price.

In a normal environment a 7.625% yield would be regarded as a poor return for a bond that could get wiped in a difficult situation, such as the crisis in 2008 and 2009. Only in a market desperate for income could a bank be able to issue bonds on such unattractive terms, particularly a bank like Barclays that has had many problems, and almost collapsed in 2008.

One of the more bizarre aspects of the Barclays CoCo bonds is that Barclays shares offer much greater security (i.e. a lesser chance of losing all of one’s investment) and a strong probability of earning a much higher return over the ten year life of the CoCo bonds.  Barclays shares trade at a 33% discount to book value, and a forward P/E of 8-9 times. Barclays ought to be able to earn a double digit return on its book value over the economic cycle, so one’s likely return from owning the shares at current prices is likely to be well above the 7.625% interest rate on the CoCo bonds.

As you may gather, I am not planning to buy these bonds anytime soon.

For my Fund, there are three broader observations from looking at these bonds.

The first is that the Barclays CoCos are an extreme example of the irrational exuberance in fixed income markets of all kinds, where investors seem much more interested in return, but are taking little notice of risk. Credit spreads (i.e. the increased yield you receive for lending to lower quality borrowers) are at the lowest levels since 2007 – and that was not a great time to buy risky assets! Our fund has almost no exposure to the bond market, and I am wary of buying shares in companies, such as insurers, that own lots of long dated bonds.

The second is that, despite their recent strength, equities are likely to generate better returns over the next few years than bonds. An example of this is Microsoft, whose 2021 bonds yield a puny 2.37%. By contrast, Microsoft shares (which our fund owns) pay a dividend yield of 3.3% and trade on a P/E ratio of about 9x, meaning the shareholder is not just enjoying a higher income, he is also likely to enjoy total returns from the investment several times greater than that of the bondholder.  

Although they are not as safe as its bonds, Microsoft’s shares have a high degree of safety, as the company has a strong business and a fortress-like balance sheet with over $50bn of net cash. Bondholders are paying a very high price for certainty of income and the perception of safety. Although Microsoft bonds deserve their AAA credit rating, and will almost certainly be repaid in full, bondholders are at serious risk from both inflation and rising bond yields. These risks are not trivial, and at a 2.37% yield, bondholders are basically receiving return-free risk.

The third is that the Barclays CoCo bonds are a great deal for bank shareholders, which other banks should copy. In January, KBC, a Belgian bank, sold a billion dollars of CoCo bonds on similar terms to Barclays and the issue was eight times oversubscribed. I am hoping that Goldman Sachs and Macquarie Group, two banks in our fund, seize the opportunity to issue as many CoCo bonds as the markets are happy to buy. It would make these banks safer, with no dilution to existing shareholders.

Those who buy Barclays, and other CoCo bonds, will probably be repaid their money, and will receive their interest. This likelihood does not disprove my contention that the CoCo bonds are a bad bet, akin to picking up coins in front of a moving steamroller.

Every credit bubble leads to a bust, in which the na├»ve investors who sought safety at any price sell their bonds in disgust at any price when they realise they have been sold a pup. This credit bubble will be no different. 


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