Why are bonds attracting retail and high net-worth investors?

market watch bonds

As the financial markets have lurched from one piece of bad news to the next over the last 9 months, there appears to be one segment that seems to be flourishing: the new-issue corporate bond market.

Bonds are simply a form of
IOU, issued by supra-national organizations, governments, banks, corporations and some special-purpose entities to help finance their operations. Purchasers of bonds come from all categories of potential investors, and range from the most sophisticated fund managers in the world, to corporate treasuries, to individuals.

This type of investment usually has a stated maturity, and infers that there is some sort of security of capital repayment at maturity. Combined with the provision of a regular source of income during the term of the bond (a coupon), these investments have features that make them attractive for most types of investors. There is always a risk of default (the possibility that the issuer of the bonds will not have the means to repay the debt at its scheduled maturity date), and there is also a likelihood that the price at any given time during the life of the bond will be different (higher or lower) than the price paid at the time of purchase.

A mantra for all investors should be the words “balanced portfolio.” A balanced portfolio is likely to contain shares, property, cash, perhaps valuables or commodities, and: BONDS. The current attraction of bonds for investors worldwide has been heightened by plummeting equity markets, the end of the property bubble, the uncertainty surrounding the financial solidity of many banks, and volatile commodity prices. Corporate bonds seem to offer some refuge from this sea of volatility at the moment, and provide a higher rate of return that bank deposits or government bonds. A specific example of this might be a bond recently issued by Roche (the giant pharmaceutical company) that pays a 4.625% coupon annually during the 4-year life of the issue. Roche raised EUR 5.25 billion with this bond as part of the war chest it is building in its effort to acquire Genentech. On the surface, the Roche issue had a lot of positives for investors: a strong corporate name as borrower (with high ratings), a medium-term maturity (4 years) and a comparatively generous yield of 4.625% (vs Italian government bonds @ 3.00% approximately). Clients put in orders for nearly EUR 10 billion of this issue, but the company “limited” its size to EUR 5.25 billion.

The Roche issue is one example of more than 40 corporate bond issues that have come to the market in the last few months and met with similar investor demand (although it is arguably the best of the bunch so far this year). Another category of bond that has met with massive investor demand has been the type issued by banks, but with the added (necessary) attraction of being guaranteed by governments. These bonds differ from the one described above from Roche in that they have been explicitly guaranteed by the government of the country where the issuing bank has its head office (primarily the US, the UK, and Ireland to date). In return for the relative comfort of a sovereign guarantee, investors have accepted lower coupons on this set of bonds (a good example of this would be the 2.75% 3-year bond issued in Sterling this week by Lloyds Bank which carried the explicit guarantee of the UK Treasury).

Leaving aside any technical questions the above information might be bringing to mind, there should be other questions that start to turn in your head. Why would a bank want/need a government guarantee to help it raise money? Why would a company like Roche need so much money? Why would investors be so keen to lock in their savings for such relatively long periods in these times of uncertainty and with such relatively low interest rates? Now the plot thickens!

These are all valid questions, and the markets would likely be less volatile if more investors asked these questions more openly, more often (and more financial advisors knew what they were actually selling). However, recent history has shown us all too clearly that very few investments get the amount of reasoned reflection that they require, and that everything is not as clearly explained as it might seem on the label. Whether it is Parmalat, Lehman, Argentina, Enron, Madoff or Iceland, these examples evoke images that have little to do with latte, pampas or thermal spas that one could hope would be the associations made by the average person in the street.

In response to the questions above and other similar ones you might be asking, investors are generally seeking a greater degree of security than they had been looking for in recent years, and these bond issues respond to that desire/fear. Does that make them good investments? Not necessarily. Does that make them the right investment for everyone at the moment? Definitely not. However, they do provide an option for investors when there are such bad market conditions for most other types of investments. Within the continuing climate of volatility, uncertainty and low interest rates, bonds are likely to be a bright spot in the financial markets provided that the current rush to bonds doesn’t create its own little bubble…

D. Roy Fraser