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Income Investor: to the pub for a 6.5% bond

Our income-hunting columnist has found a high-yielding, but risky investment. 

 
Income Investor: to the pub for a 6.5% bond

Excitement! Danger! And romance?

Well maybe not romance, after all, this isn’t about Bond the secret agent, but corporate bonds. But they can have the excitement of the higher risk that their often-juicy returns imply. I put corporate bonds at the top of my Income Pyramid because frequently you must buy a big chunk at a time (sometimes £10k or more), making it more difficult to diversify and you can lose your money pretty comprehensively if the issuing company or bank hits the buffers.

Most commercial bonds have a redemption date, when you will be repaid ‘at par’ (the face value of the security) and until then you will receive the ‘coupon’, usually paid annually. So the price you pay is important: it defines whether you are likely to receive a capital gain or loss at redemption.

There are therefore two yields to consider: the income yield when you buy (which is the coupon divided by the purchase price) and the redemption yield, or the annual yield you will receive if you hold the bond until the redemption date. Usually these are calculated for you (eg, at Bondscape).

You obviously want to make sure that the return you will get is likely to exceed inflation. You also don’t want to pay too much above ‘par’ for the security because then you would be just getting your own money back in the form of the coupon.

As a case in point, one of my highest yielding corporate bonds is Enterprise Inns 6.5% 2018, so called because it pays a 6.5% coupon and maturing in 2018. It currently has a price of around 88p, giving it an income yield of 7.3% and a gross redemption yield of just under 8.6%. (The redemption yield is higher than the income yield because of the potential capital gain.) Not too long ago, because of concerns about banking covenants, the redemption yield was up at 13%.

Enterprise Inns (ETI.L) is the largest pub landlord in Britain. However, it does not pay any dividends and a look at the share price shows that it is not highly regarded by the market, with a forecast p/e (price to earnings ratio) of just over three. The market is clearly sceptical. This is a 'non-investment grade' BB+ security and is inherently risky.

However, this bond is a ‘007’ of its class: rather than being a simple loan to the company it is a debenture, secured against a portfolio of pubs. If you check out the covenants on this bond issue in the 'deed of trust' the property is valued at ‘fair value’ as opposed to ‘going concern’ and is ring-fenced in a special legal vehicle that must equal 1 and 2/3rds of the total value of the bond issue plus two years’ worth of coupon. This property is re-valued regularly.

ETI's report and accounts noted that they 'expect to refinance the GBP600 million 2018 bond on maturity, bearing in mind that it will always be secured on a portfolio of pubs with an up-to-date valuation of GBP1 billion and interest cover of two times.' What is more, these pubs are currently generating revenue that covers the bond coupon payments twice over!

So, risk, excitement…and pubs!

If you've enjoyed this article, why not visit DIY Income Investor's blog. The views in this article are the author's own, and do not constitute advice.

8 comments so far. Why not have your say?

abbass hassan

Sep 25, 2012 at 14:19

good article .

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Robert Court

Sep 25, 2012 at 17:23

ditto re. good article.

I look at the yields slightly differently; I concentrate on the following three factors:

1. The purchase price YIELD (annual interest excluding capital gain at maturity).

2. The market value YIELD at a given point in time.

3. The total maturity value of the portfolio.

I am not too concerned about the yield to maturity as I hardly ever keep a bond that long; especially if the selling price is higher than 100 and I've already made a capital gain.

1. & 2. Are used to monitor whether a bond is keeping within acceptable yield limits.

If you set parameters then you can monitor how a bond is doing by keeping an eye on the yield.

For example, you might set acceptable parameters as yields between 8% and 10%.

Should the market price yield fall below 8% (assuming you bought at a purchase price yield of nearer 10%) then it is an indicator that you should sell and move the proceeds elsewhere.

Should the yield increase above 10% it could represent either a buying opportunity or cause for concern as this would be indicative of both a fall in price and an increase in risk.

3.) Is VITAL to maintain or increase the maturity value as income is far more closely related to the maturity value than the market value; in fact it is a fixed relationship unless you actively trade your holdings in specific bonds.

The market value represents what your portfolio is worth should you decide to sell up and could be considered to be your capital worth............I believe that the MATURITY VALUE represents a better indication of the 'true worth' of a corporate bond portfolio and that taking profits can be dangerous if the maturity value is reduced as a result (i.e. replaced with a bond at a higher price even if the purchase yield is greater).

Long term income is more related to the intrinsic maturity value than the market value (which can be quite volatile especially over the past few years).

Using the market value as a useful tool instead of being the 'raison d'etre' will probably lead to wiser and ultimately greater real wealth creating decisions over time.

'All things being equal' the bond prices trend towards their par value over time. Buying at prices well below par has an almost built-in guarantee of capital growth; the exact amount of which is known in advance at the time of purchase!

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MikeG

Sep 25, 2012 at 18:00

All good stuff ...

I like the Aviva Bond paying a coupon of 6.125% and currently trading around 89p

I bought some AXA (coupon 7.125%) below par but they have since gone crazy and are now trading at 111p which is a 13.9% profit on my purchase price ...question is do I take profits or hang on to a good coupon bond !!!!

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Cymrubach

Sep 25, 2012 at 18:11

Please advise, I am new to this sort of thing (bonds). Where can one find a catalogue of bond issues and how does one buy them.

I know this must be elementary to most of you, but it is 'beyond' me.

Thanks in advance.

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Chris G

Sep 25, 2012 at 18:19

MikeG - you could sell your AXA at a premium and re-invest the proceeds in the Enterprise bond the subject of the article and gain an immediate increase in your annual income, and at the same time lock in a further capital gain by holding till 2018, which contrasts with the certain capital loss (from today's price) that you would suffer if you held onto the AXA bond to redemption. Sounds like a win-win, assuming you don't mind a tiny bit of risk, although as stated the Enterprise bonds are a debenture, which in some eyes might make then safer than an unsecured bond. Not advice of course, just a comment!

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Robert Court

Sep 25, 2012 at 21:33

You must have bought at about 97.454 to be sitting on a 13.9% profit.

Your annual interest yield was 7.125/0.97454 = 7.31%

At market price it has fallen to roughly 6.42%

If you had 10k nominal of this bond you could sell for 11,100 + accrued interest and purchase 12,000 of a bond @ 88 for 10,560, increase your maturity value by 2k,and hopefully have about 500 left over in cash while hopefully the keeping the same income without additional perceived risk.

A 'no brasiner'! :)

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MikeG

Sep 25, 2012 at 22:11

Yes guys ..I did buy the AXA at below par and I am being stupid ..I should sell, the AXA and reivest in another bond it's too good a deal to miss ...will do that tomorrow ....Tks for the very good adice !!!

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Robert Court

Sep 26, 2012 at 10:52

Yes!

Sell now before your gains evaporate (and if the price moves higher don't be annoyed as you've made a real physical gain over a future possible loss).

I see that most of my bond prices have slipped slightly over the past couple of days; you MIGHT get a lower purchase price and higher percentage yield if you leave buying a replacement until next week if you can spare the lost accrued interest over the next few days.

However, if you can 'lock' yourself into a better yield and increase your investment incomeand increase the maturity value of your portfolio NOW without a perceived increase in risk then 'go for it'!

RJC

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