Bonds v Equities in 2011

Sitting opposite a ‘bond guy’ I am constantly reminded that the equity markets aren’t the only market and that (and I am told this is a common held view of bond guys) the vast majority of investors are simply looking the wrong way!

Based on the current outlook for equities I’m becoming a convert.

Take one of our current bond investments the AXA 6. 772% GBP perpetual bond compared to the ordinary shares in AXA. On a 4 year view, since the credit crisis began, both have offered a rocky ride but the historical returns have been miles apart.  £1,000 invested in the bond 4 years ago would have a capital value today of £700 versus the equity £350, coupons on the bond would be £270 in 4 years versus dividends on the shares of just £90. On a total return basis the bond is -3% over 4 years the shares – 56%. On past performance the bond wins hands down.

Source: Bloomberg

The bond bought today at £0.70 offers a mouth watering 9.67% p.a. interest on entry price for the next 8 years compared to a current dividend yield on the shares of about 5%, so it’s got an almost 100% uplift in income earned from day 1. In October 2019 the bond can be bought back at £1.00 (“Called”) by the issuer, which would give us capital appreciation of 42.8% on top of the 9.67% p.a. income.  Whilst it would be unusual for them not to call the bond AXA don't have to. If they don’t, bond holders will get 3 month Libor plus 2.37% on the par value indefinitely, a rate which is almost certainly above where AXA will be able to refinance. Prior to the credit crisis AXA would have paid around 1% over risk free rates for finance, so assuming the credit crisis gets resolved in the next 8 years this should be a pretty attractive rate and back stops investors against rising rates as and when we do finally emerge from the crisis. AXA has a €46bn balance sheet built up from €37bn at the end of 2008 and solvency surplus has been increased from 127% to 184%, it made €4bn profit in the first half of 2011, it does not look like a business about to go bust.

The shares today stand at €10.40 a third of their value in 2007 and are trading at about 8.7X 2010 earnings per share. 2011 half year profits per share were up 11% on same figure for the 2010 half year. For the most of 2007 AXA shares traded at 14X 2006 earnings per share so on the face of it the shares look cheap. 

But a deeper look shows the problems facing most big corporations and in particular financials. Ignoring the earnings press release and reading the full report for the 2011 HY its starts:

“In this first half of 2011, after an economic rebound in the first quarter, the economic recovery showed some signs of weakness.”

it goes on to say:

“In the Euro area, economic surveys have also shown deterioration.”

and then:

“In addition, first signs of an economic slowdown in the emerging sphere (China, Brazil and Russia) appeared, partly explained by the inventory cycle in China.”

From 2006 to 2008 AXA earnings per share fell from €2.4 per share to €0.4 per share and after recovering dipped again between 2009 and 2010 from €1.5 to €1.2, in 2010 they were still 50% lower than in 2006.

On Tuesday this week following the Greek prime ministers decision to go to a referendum on the bailout AXA shares fell 12.6% in one day. This highlights the concerns for all financial companies that own European sovereign bonds, i.e. the threat of a diluting rights issue if they need to raise more capital to prop up their balance sheets. 

To get an approximate 120% return on our bond investment in the next 8 years (£1,000 in / £2,200 back) all we need AXA to do is:

• remain solvent for those years

• repair its credit worthiness to pre 2007 levels

To get the same return from the shares would need AXA:

• not to dilute current shareholders in any rights issue in the foreseeable future

• to at least maintain dividends and not be forced into reducing dividends to shore up its balance sheet

• to roughly double its profits assuming dividends are maintained at current levels and investors aren’t prepared to pay any higher multiples for AXA shares

Of course politicians might avoid a Euro crisis and AXA may not need to raise more capital. A European recession may be avoided and AXA may well double its profits. Investors may get more appetite for AXA shares and start to pay higher multiples giving a less challenging profit target.  But there are some quite big maybe’s there and it’s not hard to see why investors are not piling in to AXA shares at these levels.

So on this longer term view the bond still looks like a much more certain way of earning a great return, although the equities potentially have more upside.

But the bond has one last winning feature that makes its selection even more compelling.

As can be seen from the chart above; recovery in the bond price from the 2008 crisis was much steeper than in the share price.  So if we do get a resolution in the Euro zone and a recession is avoided this bond will fly. The interest rate outlook has lowered in the last 3 months and 3 months ago this bond was trading at close to par value. Any resolution in the next year that sees AXA still trading and solvent could lead to a 40% plus capital gain along with the 9% plus interest. So short term the bonds potentially offer better return than the shares, with the option to switch to the shares when we have more visibility on growth and earnings and the rights issue risk is removed.

For more information on bond investing ....

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