Corporate bonds: is it time you rethought your TMS?
0The second part of my presentation at last week’s Local Authority Treasurer’s Investment Forum focused on the strengths of corporate bonds as investment opportunities for local authorities. This was followed by a lively panel discussion that included a healthy dose of scepticism from the audience, not surprising as this asset class was only opened up a few months ago for English authorities.
In simple terms, a corporate bond is a loan to a company which can be traded between investors; the borrower remains the same throughout the bond’s life, but the lender can change. I’m only talking about sterling denominated, investment grade, fixed rate bonds here, although other bond types are available. And when talking about corporates, we usually mean companies that are not banks – banks do issue a lot of bonds themselves, but they don’t provide the treasurer with anything very different to bank deposits.
So why lend to non-financial companies instead? Partly it’s a question of diversification – there are fewer and fewer high credit quality banks and building societies out there willing to accept one or two million in sterling at market rates of interest. So rather than keep increasing counterparty limits and leaving yourself ever more exposed to a low probability, high impact credit event, it makes sense to spread your money more widely. Not putting all your eggs in one basket is a good risk management lesson in any field.
Corporates also tend to be more stable and more predictable than financials, as they deal in real world goods and services, and hold more tangible assets on their balance sheets, so they are easier to analyse. Banks can only exist if lenders and depositors remain confident in their ability to repay, and confidence can change very quickly – just remember how fast Northern Rock failed after rumours started circulating about its health. On the other hand, this week’s corporate casualty, JJB Sports, has been in some difficulty for a couple of years, and the ratings agencies and investors have had plenty of time to adjust their positions accordingly.
Banks are different in other ways too. Yes, they are convenient to use, with money being their main business. But the planned banking reforms in the UK as a result of the Vickers Report will see some of the advantages of financial institutions as counterparties exchanged for some new disadvantages. For example, banks will be simplified and required to have resolution plans in place, to stop the need for taxpayer bailouts because it’s too difficult to let banks default. And part of the regulator’s resolution tools will be the bail-in, that is forcing haircuts onto long-term investors, possibly including today’s existing investors. Tomorrow’s banks may be safer for the retail depositor and the taxpayer, but it will be the wholesale investor who takes all the risk.
One good question at last week’s forum was “how would we select which corporate bonds to buy?” Well, it’s not that different from selecting which bank deposits to make. Counterparty selection is critical, of course, and all the usual tools of credit ratings, CDS, share and bond prices, financial statement analysis, etc are available. You may be surprised at how low some corporate CDS are, especially compared with similarly rated banks. Selecting which maturities of bonds are suitable comes down to your medium term cash flow forecast and your approach to interest rate risk management, as with any other investment. Any decent treasury advisor should be able to help you through these areas.
But many authorities will see the value in using a pooled corporate bond fund. In exchange for a management fee of 0.20% to 0.50%, someone with much better experience and resources will make the buying and selling decisions for you. And with the worst performing of 109 sterling corporate bond funds on Citywire still returning 2.5% in the last year (the top fund made 19.5%) you should be more than adequately compensated for taking your treasury management in a new direction.
