The Sterling Bonds and Fixed Income Handbook. Mark Glowrey
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frequently held the company’s debt, all of which has been serviced and repaid).
A quick glance at the share price
Equity investors and bond investors have different criteria. The former go for growth and may actually encourage risky and highly leveraged business plans. Thus, a soaring share price is not necessarily a good thing for bond investors. Be wary, however, of a persistently sinking share price. This is a sign that all is not well. Also, make use of the copious amount of equity research that is available, generally for free, on the internet.
Summing up
There is market saying that “there are no bad assets, only bad prices”. This may be an oversimplification, but the core of the statement is true. After making an assessment of the credit, consider the risk-reward ratio of the trade. Dubious credits may well be worth purchasing if the price is sufficiently advantageous.
Finally, do not forget the three golden rules of running a portfolio full of credits – diversify, diversify and diversify. To be more specific:
1 Diversify by industry group. This may include having a mixture of public and non-public borrowers (depending on the credit quality profile of the portfolio) before you move on to the more obvious diversifications across financial services, property, industrial, pharmaceutical and retail issuers.
2 Diversify by credit quality. Triple-B credits can show a remarkable degree of commonality across different issuers. Leven the mix with some AAA, some AA and perhaps non-investment grade credits. Consider also that different credit profile groups will behave divergently under various economic scenarios.
3 Diversify by country. Try not to have all UK credits in the portfolio.
Types of issuer
Before we go on to look at some examples of individual bonds and their credit ratings, it is worth considering the different classes of issuer that one might be likely to come across in the sterling bonds markets.
Sovereign issuers
As a rule of thumb, the bonds with the least risk of default are the high quality sovereign issuers such as the UK and the larger and wealthier European countries such as France and Germany.
The industry has traditionally considered such assets to be risk free from a default point of view. This type of thinking is perhaps outdated, however the risk of default [2] for bonds issued by these countries can be assumed to be low, and lower than the risk from a bank deposit. Ranking alongside these are the Supranationals, these being agencies such as the World Bank and the European Investment Bank which are guaranteed by their sovereign members.
Second to this are the second-line countries, and those experiencing some economic difficulty. Here I would give Italy and Japan as two examples. While these countries do not have the economic strength of some of their peers, it is fair to say that they have a lower risk of default. This type of debt should not be confused with emerging market bonds, which historically have carried a much higher degree of risk. Recent events have propelled some of the more marginal sovereign credits into the spotlight, with bonds issued by Greece and Ireland trading wildly in the markets as investors consider the likely outcome of these countries’ dire financial situation. It is likely that there will be some instances of at least partial default, and the creditworthiness of second-tier sovereign debt re-evaluated accordingly.
Bank issuers
Next we have high-quality, non-governmental debt. In the past, the highest scorers have often been the banks, some (but not all) of which have credit quality to rival that of a government. However, this situation has been affected by the events post-2008, and bank bonds now often trade on higher yields than corporates. Current moves from Brussels to effectively subordinate bank senior debt to deposits may see this prove to be a permanent development.
The seniority of the issue is of particular importance in bonds issued by banks. Bank debt is usually ranked as follows:
Senior Debt: after secured bonds, this is the best.
Lower Tier 2: the bank does not have the right to defer the coupon. The next best after senior debt.
Upper Tier 2: coupon deferral possible in certain circumstances, but coupons are cumulative (i.e the payments missed will be rolled up and paid when the bank returns to a more favourable situation).
Tier 1: coupon deferral in certain circumstances, non cumulative.
Preference Share: generally coupon payment can be waived, generally non-cumulative.
Corporate issuers
Finally we have corporate bonds. These are bonds issued by corporations, typically large quoted companies. The life of a company is full of ups and downs and it is fair to say that in most cases corporate bonds carry a greater risk than those issued by major governments or banks. Factors affecting a company’s credit rating include cash flow, profitability, asset valuations and unforeseen events such as legal action, a takeover or a change of the trading environment. Historically, the yield on these bonds will normally be greater than that available on bank debt and it is unusual for a corporate to achieve triple-A status.
It is notable that during the credit crunch of 2008 onwards this relationship has inverted with bank debt trading wider than corporate debt. Most market participants expect this relationship to revert to the historic norm in due course, but time will tell.
Other types of issuers
There are numerous bonds issued to fund mortgage loans, credit cards loans and other more complex financial transactions. These types of bonds, often known as mortgage-backed and asset-backed, are not generally available to the investing public in the UK. The credit quality of these varies from excellent to poor, typically depending on their place within the pecking order of claims to the underlying assets. Secondary market liquidity is often poor.
Some sample issuers and their ratings.
In the following table I list some of the better known borrowers and their current credit ratings.
Note: These samples are based on the rating in force in early 2011, and are subject to change.
Frequently asked questions
Will a highly rated bond be less volatile than a lowly rated bond?
To a degree, yes. The perception of risk will tend to fluctuate less. However, the influence of interest rates, both in the present and to come will exert a similar influence on both highly and lowly rates bonds alike.
What are junk bonds?
The expression junk bond is a colloquialism for a non-investment grade bond (i.e. a bond that is rated below BBB-). In truth the term junk is often a rather harsh description and the majority of these bonds will live a useful and uneventful life, servicing both coupons and redemption payments. Nevertheless, a risk of default is implied in the name and caution should be applied when dealing in these bonds. At the time of writing, examples of bonds with junk status in the sterling markets include GKN, Manchester United and Cable & Wireless. As might be expected, these types of bonds offer a higher yield (7-10%, compared to gilt yields of 2-3%) in order to compensate for the additional risk.
Can credit ratings change?
Yes, indeed they can. Although the ratings that investors follow are described as long term ratings by the two main agencies, they can swing around quite