Money

Company bonds

Updated: 01 May 2009

Introduction

The interest rates are tempting but are company bonds as good as the hype suggests? We take a look.

Some of our biggest companies seem in a mad dash to borrow money - not from their banks but from managers of KiwiSaver funds, institutions such as ACC, and people like you and me. They're doing it by issuing "company bonds" with interest rates that appeal to people looking for alternatives to the banks' term deposits.

How do they work?

When you buy company bonds you're lending money directly to the company. As part of the deal, you get regular "interest" (coupon) payments - and your principal comes back to you at a pre-set date when the bond matures. Some of these bonds are "subordinated", which means there are other creditors (those with "senior" debt) who will rank ahead of you in the creditors' queue if the company defaults.

If you don't want to hold the bonds until they mature, you can sell most of them on a secondary market to another investor. But that will be at the market price for those bonds at the time you want to sell (assuming there's someone who wants the bonds).

The investment bankers who create the bonds for their corporate clients are happy to point out the positives of DIY bond investing - "safe" names, higher returns than you'd get from term deposits, and no fee-taking fund managers.

But it isn't as straightforward as that, as we explain in what to watch out for.

Alternatives to DIY bonds

Buying directly is not the only way to invest in company bonds. You could also purchase units in a retail collective investment scheme that specialises in bonds. The AMP Capital NZ Fixed Interest Fund is the biggest, at around $600 million.

Here you're investing in a professionally managed diversified pool of bonds (including government and non-retail bonds) for a fee of 0.55 percent of the value of your investment each year plus expenses and entry and exit fees. Anthony Edmonds from AMP Capital Investors believes that large fixed-interest funds receive better deals on bonds than DIY investors (which may result in higher yields) by avoiding the significant brokerage fees DIY investors have to pay.

Unlike DIY bonds, units in a collective investment scheme have no set term of investment and you can't lock into a return. When you want to cash up, you sell the units back; what you get for them depends on what the pool of bonds is currently valued at. So you'll always be exposed to the risk that the units end up being worth less than you paid for them.

There's also a risk your money may be frozen if the fund gets into trouble. This can happen if investors want more money back from the fund than the fund is able to repay by selling bonds - for example, if the bonds are in default or can't be sold. This has happened to a number of mortgage funds in the past year.

What to watch out for

The risk of default

If the bond is a debt security issued by a bank or guaranteed non-bank "deposit taker" (such as some finance companies) and it expires before October 2010, you may have no real risk of default. That's because the bond may be covered by the government's retail deposit guarantee scheme (always check before investing).

If that isn't the case, then default is a possibility. In the current state of economic turmoil five years is a long time - and many of the new bonds have been issued for 5-year terms.

In some cases, even if the company goes into default, you may not be badly affected. It depends on what type of bond you have.

Not all lenders are equal

If you have a "senior" bond, rather than a "subordinated" one, and the company goes into default, you have first access to whatever funds are available to creditors. So you might get all your money back.

If you invest in a subordinated bond, banks and other investors that hold senior bonds, or are senior-ranking creditors, will have more rights than you in the case of default. And unless it specifically says so in the prospectus, there's nothing to stop companies arranging more senior debt later - pushing you further down the creditor queue.

Tip: Don't rely on the name of the security for finding out whether your bond's status is "senior" or "subordinated" or has other conditions attached - take a look at the prospectus. But even then you (or your adviser) might need to get advice from a commercial lawyer.

Rated vs unrated

Companies issuing bonds can be rated by agencies like Standard and Poor's or Moody's. This involves assessing the creditworthiness of the company and/or the securities it issues. The agency does this for a fee and at the request of the company.

The agency gives the company or bond an investment grade rating if it's assessed as having a relatively low risk of default. Bonds with a Standard and Poor's rating from BBB- to AAA are investment grade, with BBB- bonds being "more subject to adverse economic conditions".

But ratings' agencies are not always right: Macquarie Generator (Commodity) Bonds came with an investment grade rating but were still a disaster for investors (see "Other bonds").

Not all companies choose to get a credit rating. Their bonds are "unrated" and you only have your own analysis, or your adviser's, to go on.

Other checks

As well as the credit rating, you (or your adviser) need to make a judgement on how well the company will do over the life of the bond. This involves looking at the prospects for the business the borrower is in, the track record of its management, and what the company intends to do with the money it raises.

This means much more than a quick read of the investment statement. The prospectus and the financial statements also must be looked at. These give much more detail about the prospects of the company - and, for unrated bonds, this information is all you have to go on.

Payments and cashing in

Getting regular payments

Let's assume the company doesn't get into difficulty. In that case, holding on to the bond until it matures will mean that your return will exactly equal the "yield to maturity" of the bond at the time you bought it. The yield to maturity takes into account when the coupons (the "interest") get paid, how big they are, the amount you invested, and when the principal is due to be paid back.

Bernard Hickey

The yield to maturity is much the same as the interest rate on a term deposit. The yield to maturity can be quite different to the coupon rate (or "current yield"), so don't rely on the coupon rate as a guide to your return.

Tip: The greater the risk, the higher the return you should receive. The interest rate doesn't look as if it reflects the risk? Then avoid the investment.

Bernard Hickey (pictured right), editor at interest.co.nz, gets concerned when he looks at the returns offered on some of the riskier bonds - some of the rates offered aren't great when you take into account that bank bonds and deposits are currently government guaranteed.

Cashing in early

You need to think about whether you might need to get out of the bond before it matures.

Many company bonds can be bought and sold during their life - usually on the NZX debt market (NZDX). If you sell your bond before it matures you'll have to accept the market price for the bond and that might be less than you invested.

Many factors influence the price of a bond. But one of the most important is interest rates. If interest rates rise after you buy a bond, the market price of your bond will fall until its yield to maturity matches the yields in the rest of the market.

Anything and everything that affects interest rates can affect the value of your bond.

Rising inflation, concerns about the currency, bad news on the government's budget deficit, or a flood of new borrowing by companies and others ... these all have the potential to lower the value of your bond investment.

But a deeper-than-expected recession might increase the value of your bond - because interest rates are likely to become lower, making your bond more valuable.

All this matters only if you sell your bond early. It's similar to what happens when you break a term deposit early: if rates have risen since you invested, you pay a penalty to the bank (because they now have to borrow from someone else at a higher rate).

The price of a bond can also move sharply with news about it or a change in the financial markets' view of the company. For example: if the company can't renew other funding, its creditworthiness suffers and down goes the market price of its bond.

Tip: If there's a chance you might sell your bond before it expires, it's absolutely essential for you (or your adviser) to investigate the company thoroughly both before you buy the bond and during the life of the bond. You also need to regularly track the price of the bond.

Jargon busting

"Secured" bonds or notes give you a direct claim on the assets of the company if it goes into default. It's better to be secured than not but, as the finance company debacle showed, assets may not be worth anything by the time a company fails.
"Convertible" bonds or notes means the company doesn't have to give you cash when the bond matures. Instead it can choose to return your principal in the form of shares in the company.
"Callable" bonds means the company can repay you early (for example, if interest rates have fallen and it wants to get cheaper funding). So you don't have a guaranteed "locked-in" return.
"Perpetual" bonds have no set date for repayment and can pay coupons forever. When you want your money back you have to sell the bond (if you can find a buyer) and accept whatever price the bond is trading for.
"Floating rate" notes or bonds have coupon payments which are re-set regularly. The coupons are based on a benchmark interest rate such as the one-year wholesale market swap rate.

Our advice

Unless you have first-rate financial-analysis skills, go for rated rather than unrated bonds.
Spread your investments across bond issuers and look for different expiry dates.
Before you invest, thoroughly investigate the company and the bond (including the bond's status if the company fails).
If your adviser doesn't understand company bonds well, find another adviser. Don't accept uninformed advice.
Look for relatively higher returns from subordinated bonds.
Keep in mind the returns available from government-guaranteed term deposits over the next year.

Other bonds

New Zealand government bonds can be bought by ordinary investors. They come with the highest Standard and Poor's rating (AAA). If you want access to the higher yields available on the wholesale market the minimum investment is $10,000. In April 2009 the wholesale market yields on bonds maturing in 2015 were around 4 percent. You can also buy retail issues of government bonds (called Kiwi Bonds) with a minimum investment of $1000.

Some bonds operate like collective investment schemes, where the money raised is invested in financial assets and the bond issuer administers the investments. These are called "structured bonds". There have been some high-profile failures of structured bonds recently: Macquarie's Generator (Commodity) Bonds and Absolute Capital's PINs now trade at what's called "distressed" yields ... with serious capital losses for many investors.