Owning government debt, ISAs or equities is no guarantee you can make or even keep your money, let alone beat inflation. That’s why bonds from solid companies are your path to growth, says Peter Doherty of Tideway Investment
WE LIVE IN unprecedented times. For all intents and purposes, the available return after costs on five-year government bonds from the world’s largest economies is zero. After inflation, the return is negative. These bonds now offer return-free risk.
In short, savers are footing the enormous bills of the US housing crisis, the banking crisis and now the eurozone crisis, not to mention the UK’s own problems arising from an imbalanced economy, low tax receipts and zero growth. In addition, it is estimated that over 60 per cent of ISAs are cash, meaning that even with tax-free income investors are suffering from capital erosion in real terms.
So how can investors beat inflation and protect capital without locking up their money for years? By taking advantage of one of the most widely acknowledged and discussed aspects of the current financial crisis: the shrinking of the banks. Here’s how.
It is widely accepted that banks generally became too large and complex in the twenty years prior to 2008 and that what they need to do now is simplify their business and have more equity (capital) to absorb losses than was previously assumed. So as have seen from recently reported figures (EBA, Federal Reserve) banks are shrinking their balance sheets and lending less.
In turn, this means that many sound companies who previously might have borrowed everything from a bank are now looking for another place to borrow money from. The best place for some of this money to be borrowed from is the bond market.
This means that well-known companies are issuing bonds for the first time or are issuing more bonds. And some of these bonds can be attractive for investors because the first time or more frequently an issuer borrows via the bond market, the more they want to make the bond a success in order to build a following. There may be a bit of extra return available for investors.
So one starting point for investors who want to earn a return to match or beat inflation is to look for household name companies who are raising money in the bond market. These should be ordinary bonds from stable, well capitalised companies. The sole condition for full and timely repayment is that the company remains solvent.
The next idea to think about is how companies today can raise equity capital. The vast majority of public companies do not want to issue new shares to raise capital as this dilutes existing shareholders. So many companies issue ‘hybrid bonds’ or ‘preference shares’ which generally have more risk and higher yields for investors.
The key to successful bond investing is avoiding losses, which come from an inability to repay and an unwillingness to repay.
Therefore, investors seeking higher returns should always ask, ‘Does this company care about its reputation? What impact would a decision not to pay have on the company?’
As a guideline, any riskier bonds should be bought only from the safest companies with household names. In the current climate, there is no need to buy anything you are not entirely happy with or are unfamiliar with.
Remember: there is a very high degree of certainty that this cash-flow will actually be paid. Subject to the specific terms and conditions of the bond, paying the interest and principal is a contractual obligation of the borrower.
The usual safety-first guidelines apply: don’t use leverage; only buy bonds from companies you know and trust; diversify across a number of bonds; invest with a medium term horizon, not for short term gains.
Peter Doherty is CIO of Tideway Investment Partners