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Retail bonds: do the risk and reward match up?
Bond fund manager Stephen Snowden highlights his concerns about the Severn Trent retail bond launched last month.
Severn Trent became the first water company to plough into the retail bonds market last week.
With so few inflation-linked products on the market right now, the 10-year sterling bond paying an annual rate of 1.3% adjusted for RPI inflation looked like a pretty tempting deal – especially since NS&I has confirmed it is not going to re-launch its own index-linked bonds this year.
However, according to bond fund manager Stephen Snowden, the Severn Trent deal – which is due to be withdrawn today – might not be quite as sweet as it sounds.
Look carefully at where the bond came from
‘Obviously you have to qualify everything I say because as a bond fund manager it isn’t in my interest for people to buy retail bonds direct from companies, but I can point out a few things,’ Snowden, co-manager of the Kames Absolute Return Bonds fund, began.
First, investors should be aware of which part of the Severn Trent business issued the bond.
Unlike Severn Trent’s wholesale bonds which are issued out of its operating company, its retail bonds are issued out of its holding company – like the company’s shares.
As an investor you might be thinking so what? I’m still investing in Severn Trent.
However, as Snowden explains, the operating side of a utilities company like Severn Trent benefits from regulatory protection – in this case from Ofwat – whereas the holding company doesn’t.
The regulatory ring fence is designed to limit the amount of debt the company can have to ensure consumers and businesses aren’t at any risk of being left without water. This regulatory protection, however, is not extended to its parent holding company.
‘And it isn’t just me that thinks this,’ Snowden said. He refers to Standard and Poor’s, one of the world's leading credit rating agencies, which has a BBB+ rating on Severn Trent’s operating company. This is towards the low end of its 'investment grade' ratings, which means the company's ability to pay interest on its debts could be weakened by a bad recession or some other unexpected blow. However, this is better than the holding company's rating, which is BBB-, which is two notches lower and just one step above 'non-investment grade'.
‘People look at Severn Trent and think what can go wrong – and 99 and 100 times they’d be right,’ said Snowden. ‘But if the last few years has taught us one thing it’s to expect the unexpected in the markets and I’d always rather have regulation there than not’.
Paid less for more risk
What’s more, in the case of Severn Trent investors are being paid less to take more risk, Snowden added.
Institutional investors like Snowden can buy the company’s wholesale index-linked bond and get a 1.5% return adjusted for inflation, whereas retail investors get 1.3%. And while the wholesale investor is lending for longer, and therefore should be compensated with a higher rate, he says there is still a ‘small income disparity’ given retail investors are taking a bigger credit risk.
Severn Trent has put in a change of control clause into the bond, though. This means that if Severn Trent is bought by another company with lots of debts (and a worse credit rating), the coupon - or rate of interest paid by the bond - will increase to 2.3%, adjusted for RPI.
Snowden concedes the 1% coupon step-up offers investors 'a degree of protection’ but adds: ‘Although personally I’d rather go for the high yield with high protection than rely on the 1% step up which is scant compensation for that scenario,’ he added.
The holding company is better known
This isn’t the first time Snowden has warned private investors about the structure of retail bonds. The popular National Grid retail bond launched in September last year was also issued from its holding company, he said, similarly forgoing regulatory protection.
Yet as Henrietta Podd, head of debt advice for investment bank Canaccord Genuity, highlighted, ‘shareholders are exposed to the same risk ... and many retail investors are comfortable investing in shares of holding companies’.
‘Companies opt to issue retail bonds through holding companies like shares because that’s what retail investors are most familiar with, and it’s worth pointing out that the regulator does look at the strength of the entire group,’ Podd said.
Michael Dyson, of Investec, which is marketing the Severn Trent retail bond, meanwhile added that holding companies are more transparent as these are the entities issuing the shares and paying the dividends.
'When issuing to retail investors companies have to comply with EU directives – such as certain accounting standards for example – which the holding company already does as a matter of course,' he explained. 'It can be difficult to create the same level of disclosure in the operating side of the business'.
Do the risk and reward match up?
What's more, the good thing about retail bonds is that they are not an exclusive area for very rich people – investors who don’t want to invest hundreds and hundreds of thousands in bonds can still buy six or seven bonds to get diversification, Podd explained.
Dyson, meanwhile, added that the key to retail bonds is that they offer investors a fixed interest rate and a fixed maturity date, and are therefore a useful financial planning tool.
Snowden, however, claims a bond fund allows you to benefit from a much greater degree diversification, adding that ‘just because something is accessible doesn’t mean it is right'.
‘I would question the logic of buying very small amounts of one bond – as even without the annual management charge you’d pay to invest in a bond fund it could work out to be costly to trade if you want to cash your bond in early on the London Stock Exchange,’ he added.
At the end of the day, as Podd said, you need to look at the risk you’re being asked to take and look at the reward being offered – are you getting an appropriate reward for the risk you’re taking?
For more information on how bonds work check out Gavin Lumsden's video 'What are bonds and how do they work?'
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