Bonds V Equity Update

Since my last post here is the progress of the AXA bonds and ordinary shares:

• Bond -8%, ordinary shares -26%. Pretty ugly for both but more than 3 x the pain in the shares versus the bonds highlighting the leveraged nature of equities.  Note the shares will need to recover 35% now just to repair the damage of the last 3 weeks.  We remain very comfortable with AXA credit knowing the improvements in the balance sheet since 2008 and their ability to pass out pain to both shareholders through lower dividends and policy holders in lower returns before bond holders become at risk.  We feel conviction to continue to hold is much easier with the bond than with the shares.

Source: Bloomberg 

• Inflation coming?  This is held out week after week in the financial press as to why you should not own bonds. Interest rates will rise making bonds fall in value.  And yet in reality the opposite is happening. In the last 3 weeks 10 year Gilt yields have been pushed down from 2.5% to 2.14%, the chances of a UK base rate rise is now generally accepted as off the table in 2012.   

Source: Bloomberg

• The wrong kind of inflation.  Oil prices remain stubbornly high, no doubt driven by emerging market demand. Not good for consumers as it eats away at spending power through higher travel and energy bills, not good for equities as it raises operating costs for many businesses.  

Source: Yahoo Finance

Tideway Bond of the week (may be the year!)

Medical insurer BUPA, 6.125% coupon perpetual with a call date at par in Sept  2020 or moves  to  5 year gilts plus 1.6%, price today 73p. Key features we like:

• Minimal exposure to European sovereign debt crisis
• Sound simple business, relatively recession proof
• 8.4% yield for 9 years on investment cost
• Potential  37% capital gain on top of yield if called, gives 11% return to call date
• Move to 5 year gilt yields gives insurance long term against rising rates
• Traded above par in 2006 and at 90p as recently as April 2011, so potential for strong upside if debt crisis is resolved
• Pricing of these bonds is largely broken as banks and some hedge funds are forced sellers 

Source: Bloomberg

Peter Doherty says in describing the Bupa bond as good value:

“By "good value" I mean,

 1. There is a very high degree of certainty that an investor will get the principal amount of the investment back. Safety first.

2. The annualised return for a medium term holder can reasonably be expected to be well in excess of inflation. Here 11% p.a. is the base return.

3. In a normalisation of the credit markets, the bond price will revert to 85 / 90 giving an annualised yield for that annual period of circa 20% (15 points of price + interest)

4. The underlying business of the issuer is stable and if for any reason the company did get into trouble it wouldn't be unusual for new equity investors to appear ahead of a default.    

The price history chart shows the bonds are priced midway between the 2008 / 9 worst pricing and the prices seen earlier this year pre the Eurozone crisis. Where we go from here into 2012 is clearly a driver of how much appetite there is or investing at this time. 

Subject to some "bond by bond" analysis, it's possible to find similar stories in Zurich Financial, Legal & General, Standard Life, Clerical Medical etc.  These investments can underpin the Navigator and "Safety First" Private Client Portfolios.”

Note always remember the value of investments and the income they produce can fall as well as rise you may not get back all your initial investments. 

This note is not intended as advice to buy any of the securities mentioned, if you have any doubts about and investment always consult an investment adviser before investing.

JB

24/11/2011

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