Paul Scott interview with Paul Hawkins, corporate bond specialist

Paul Scott interviews corporate bond specialist, Paul Hawkins

Recent rises in interest rates, and turbulent equity markets, have meant that some investors are looking at corporate bonds as potential investment ideas. Offering more safety than equity, and a predictable income stream, is there any merit in considering investment in bonds? We explore the various aspects in this interview.

NB. This is absolutely not investment advice. Bonds can be complex, and are best left to the experts, if you don't have relevant expertise.

Paul Hawkins has specialised in corporate bonds, in senior city roles, for most of his career.

Tamzin at PIWorld interviewed Paul in this outstanding video from June 2020, which I suggest you watch first, as my audio interview tries not to overlap too much with this.

Click here for my audio interview on my website. Or, search for "Paul Scott small caps" on podcast platforms.

As an additional service for Stockopedia subscribers, I have typed up a summary (almost a transcript as it turned out!). Please don't copy/paste this onto other websites, many thanks.

Q1. Bonds, what are they, it’s just debt isn’t it?!

A1. Yes, an issuer asks to borrow say £100, and pay you £5 per year interest, and at the end of 5 years, they give you £105 back. (Clarification: redemption = 100. Final coupon 5). 

Q2. Who buys bonds - why, and where does the money come from, it’s a massive market I believe.

A2. Yes, £174bn of sterling issuance (excl. Gilts) were issued last year. £1 trillion is size of market, £4 trillion if you include Gilts. The major buyers are household names, e.g. M&G, Legal & General. Pension funds buy Gilts to save for future liabilities (paying pensioners).Also bond investment funds. Also sovereign wealth funds, e.g. Norway. Japense/Korean pension funds, or a fund manager anywhere that likes sterling debt. Diverse world. Institutional, not retail investors.

Q3. How are bonds priced? They’re issued par, or 100. Then the market value can go up or down.

A3. Not everything is priced at par. Benchmark yield is Govt debt yield, then there’s a spread above that for corporate bonds. So investors negotiate what they wish to buy. An example - ASDA was pricing bonds at 4% last year, but now the spread is much wider than that.

So the price moves by 2 elements - the benchmark Govt debt moves all the time, and the perceived credit risk of the bond issuer. Price is only set when the trade is agreed (on the spread). This is why bonds are attractive now, because the Govt debt yield has risen so much.

Q4. Now QE seems to have ended, bond yields are looking much more attractive to me, as a possible alternative to equities.

A4. Absolutely. If you’re an average investor, looking for say a 10% annual return, if you can buy bonds yielding 12-15%, higher up the capital structure than equity holders, then that’s very interesting. People are waking up to that now, but there’s a lot more to go on it. The day before the Bank of England started their recent buying (to stabilise the market), the level of buying was astronomic. People were looking at >5% long-dated Gilt yields, and seeing that there would be a good running yield, and a capital gain. People made 20-30% in 10 minutes.

Q5. What about maturity date & yield to maturity?

A5. There are bonds for every eventuality. Expiry date is set at launch, say x years after the launch date. The prospectus can run to 700 pages, very few people read them, mostly legal. You know exactly what the cashflows will be, so your only risk is the mark to market price of the bond (and rarely, default risk).

Q6. Wouldn’t that mean the market is illiquid, if investors hold them to maturity?

A6. The market is highly liquid, and I used to trade £100m per day. Market makers make prices in £10m per trade routinely.

Q7. Not much of a culture of bond ownership in the UK, for retail investors. How would we go about it? Do we need to worry about bid/offer spreads?

A7. No, because you’re only interested in the bond’s yield. It’s over the counter market, so bid/offer prices are not published. You can buy bonds through stockbrokers. They tried to push the retail market in 2009, but issuers realised that private investors need too much hand holding. Had bad press. Use a stockbroker, and find the bond you want to buy. Some are listed on the London Stockmarket, which settle through CREST. Or Euroclear. Private banks are the rest, and they’ll send you a list of about a thousand bonds to look at.

EDIT: Paul H sent me this clarification note on A7 -

"I think I explained this poorly. My point was essentially that the bid/offer spread isn't really important in the trade, if you hold to maturity, as if the yield is attractive enough then you do extremely well if you hold to maturity."  End of edit.

Q8. I urge people to watch your interview with Tamzin of PIWorld in June 2020. I’m trying not to overlap too much with that content. The concept of equity ranking behind debt - could you expand?

A8. If a company defaults, then HMRC & others rank first. Say if MADE.com defaulted, if it had bank debt, then the assets are sold, and senior bank debt (secured) would be paid out by the liquidator. Then the junior debt holders get paid, then next the preference shares holders. If there’s anything left after that, it goes to equity holders. A lot of people in the UK don’t realise this. In Belgium & Italy ordinary people know that bonds are a more protected investment class, and they buy them more readily than British. Bond holders don’t have the upside of equity holders though, multibagging. But you also don’t have the downside risk of equity. For the first time since 2011, bonds are now presenting interesting yields.

Q9. What are the minimum quantities to buy bonds?

A9. MiFiD caused problems, by requiring much more detail in prospectus. This caused issuers to target institutions, not retail. So most new bond issues now have a minimum of £100-200k. But there are retail issues with a minimum as low as £1k. The ORB is probably the best place to look. Stockbrokers will have a list of retail bonds. People like Mark Glowrey are particularly good.

Q10. Finding information about bonds - is difficult. You said previously people should just google it, but I struggled to find much info. Hargreaves Lansdowne’s website lists some info on bonds, but only a fairly small number. Where can we find more detailed info?

A10. You’ve highlighted that there is a gap in the market. Stockbrokers try to avoid this area, over fear of regulatory problems. Ask your broker to speak to Winterfloods, Peel Hunt, or Canaccord, they may well have lists of available bonds. It does require some digging, to get lists of bonds, but the brokers do have them.

Q11. I forgot to do the disclaimers early. We’re not recommending anything or giving advice. It sounds like the best first step, if you’re interested in bonds, is to approach your existing broker.

A11. Yes, just tell your broker what you’re looking for, say a 5-year bond in a financial, or other company, what can you get for me? If your broker says “nothing”, then they’ve not even tried to look!

Q12. Let’s talk about an individual bond, SAGA plc, the shares have been a disaster for me, but it has two bonds in issue. I have looked at the terms of the bonds, and the separate ship loans, and I think these are fairly safe. But I noticed the 2026 SAGA bond, the coupon is 5.5%, but the value of the bonds has fallen from close to par (100) at start of 2022, but have since fallen to about 65. That gives a yield to maturity of about 19%. Could you explain yield to maturity vs coupon, using this as an example please?

A12. I prefer the terminology “Gross Redemption Yield”. It’s the same thing, it includes the running yield (the coupon), plus any capital gain. If you buy a bond at par, then the yield is just the coupon. If you buy SAGA bonds at 65, then you have the 5.5% coupon (running yield), plus a capital gain of 35 points (when it is repaid, on expiry, in 4 years' time). It would probably be a qualifying corporate bond (QCB) so the capital gain would be tax-free. Your coupon would be taxed though. So the running yield can be very different from the gross redemption yield.

Q13. Let’s touch on the tax free element. What constitutes a QCB?

A13. It is in the Finance Act. Criteria to qualify as tax-free capital gain - post 1982 issued. Mustn’t be convertible. Can’t convert into another currency, there are about 4-5 conditions. Maturity can’t be extendable. If it’s a plain vanilla bond and issued in sterling, then the capital gain should be tax-free - an enormous benefit right now. Why? I’ve no idea, it’s just in the Finance Act. People care about it at times like this. Google "QCB" and the terms are pretty clear.

Q14. If I wanted to park say £100k in SAGA bonds, then if I’m worried about equity being diluted in another equity raise (one of my SCVR readers thinks this is likely, but I disagree) then the bonds might be a better bet than the shares. So a yield to maturity of almost 19% on SAGA bonds, could be attractive, and lower risk than the equity? How do they interact?

A14. An element of that high yield is reflecting refinance risk. If SAGA can’t refinance it (in 2026) then they would have to turn to equity holders. But this risk is often overstated by bond markets in terms of stress. Bond markets have to remain open, in order for economies to function. A company like SAGA can access finance. L&G or M&G will give them a price, for a £250m bond, which can be done on a phone call! It’s a function of - do we understand this company? Do we think it’s going bust? What do we want in yield? Same as banks, who want to lend, but it depends on price.

Q15. SAGA’s market cap is so small now, only just over £100m. Why don’t more small-mid caps access bond markets? When they don’t have to worry about net debt: EBITDA covenants, as you do with bank lending?

A15. You absolutely do have to worry about covenants (with bonds). The SAGA bond explicitly references SAGA's RCF (bank facility) covenants - net debt to EBITDA, and interest cover, I did look into it. So whilst there are no specific covenants in the SAGA bond, they reference the RCF covenants, pari passu. So if the RCF covenants are triggered, that would trigger a default for the bonds too.

Paul S: but SAGA doesn’t use its RCF, it’s undrawn. It has gross cash of about £170m, and the unused RCF is only about £50m?

Paul H: I’m not sure, but just because SAGA isn’t using the facility, it’s still available on demand. If they were extremely bullish they might decide not to have the RCF facility.

Paul S: assuming that a different company is funded entirely by bonds, the bonds wouldn’t contain financial covenants would they?

Paul H: It depends on who the issuer is. Gives examples of a very low risk, and a very high risk issuer. You would demand belt & braces covenant for a high risk issuer.

Paul S: But those are very extreme examples. Say for a typical, solid mid-large cap, would their bonds contain covenants?

Paul H: Absolutely, yes they would. Walmart probably wouldn’t have covenants. Tesco have some covenants on their bonds. If you go smaller, Victoria Carpets have bonds.

Paul S: I think Victoria said they’re bonds are covenant lite, with lesser covenants than bank lending.

Paul H: There would be covenants in that kind of issue - e.g. net debt to EBITDA, interest cover, there’s a whole range of covenants for almost every issue. To answer your question about why more small-mid caps don’t use bonds - because it’s extremely expensive, lots of agents fees. Also listing fees, which can be in Rome or Guernsey, as it’s marginally cheaper than listing them in the UK. Plus there’s the amount of time management have to spend with bond investors, they’ll ask far more searching questions than equity investors will ask.

Paul S: I stand corrected on the covenants issue, how interesting.

Q16. Some friends are distressed bond investors, who do incredibly well out of it, over a long time (10 years+). They come across junk bonds, where institutions have become forced sellers, but there’s little real world chance of default, and they seem to do very well on junk bonds, when they recover. So can you tell us a bit about junk bonds? What are they, and are they really junk, are there opportunities?

A16. “Junk” just means it’s sub investment grade. A lot of funds have rules that they become forced sellers if it goes below investment grade, that’s what creates the selling pressure. It absolutely doesn’t mean it’s going to default necessarily. High yield is another term for it. There’s a greater risk of default, but it’s not an inevitability. Take SAGA as an example. On my Bloomberg terminal, there is a 5% mathematical chance of default. But is it likely to default? As an equity investor you know just as much as debt investors. There are many levers, if SAGA thought it might default, they could sell their insurance business. Plus the founder’s son refinanced it, so he could probably refinance it with more equity if needed. In normal circumstances, he could just refinance that bond with a new bond.

Anything over about 12% yield would be classed as a distressed bond. If something does default, the usual historical outcome is that bond holders get about 40p in the £1.

Paul S - it strikes me that a lot of the skills to assess bonds are the same skills a value investor has for equities.

Paul H - Absolutely! A company is a company, whether you’re equity or bond investor. Distressed debt funds in 2009 were buying up debt in UK companies like Daily Mail, ITV, and as you just said, they knew these things were not likely to go bust, on say 17% yields.

Paul S: I’ve only ever bought one bond, when RBS Prefs were yielding 62%! (in the 2008 financial crisis).

Paul H: Great trade! We had one, once in 2009, that was yielding 100%! So you only had to collect in one coupon!

Q17. What’s your take on the recent LDI trades that caused so much disruption?

A17. Terry Smith summed it up well recently. They wanted to reduce risk for pension funds, but it caused financial engineering, which the regulator endorsed. But events with the Govt (mini budget) caused a more extreme movement. That Gilt market movement was seismic, I can’t remember anything like it. Had Kwasi Kwarteng not said/done what he did, it probably wouldn't have happened. There are aggressive players in that market. But I never saw any malpractice, but the more aggressive players probably leveraged more than they should have done.

Q18. Looking at higher inflation, 10% now, then 7% next year, then lower in 2024. So getting say 5-7% yields on safe bonds, and more on riskier ones, could this be a good place to look for income, rather than investing in equities?

A18. Absolutely. We’re now seeing bond yields that haven’t been seen for 12 years. Locking in a high yield now could repay you very well in future. Dependent on what happens to inflation. ASDA issued £4bn, Morrisons are now yielding 15%, and Marks & Spencer bonds are yielding over 10%, but are they really likely to go bust?

Preference shares are far easier to access for private investors, look at those. Also a buyback story, e.g. banks want to buy them back, as they won’t count as capital. Quite an arcane story. Lloyds tried it last year. Aviva messed it up. Potential for a nice capital gain with prefs.

Q19. Are there any collective investment vehicles for bonds?

A19. Yes there are lots. M&G have big bond funds. Royal London, others. Eric Holt has been there through the cycle, at Royal London Asset Mgt.

Q20. Are the fund manager fees reasonable?

A20. Probably about 1%.

Paul H: I bought investment trusts if they’re at a discount, and if you like the top 10 holdings, then they’re worth a look. There are bond funds to suit every taste.

Thanks & goodbyes. Where can we find you on Twitter? @Hawkeye_74