Article 4.9 Watchdog sounds alarm over corporate bond fUnds

By Emma Dunkley

Financial Times July 29, 2014

Investors buying funds that hold corporate bonds risk losing a significant amount of capital if interest rates rise and will find it hard to sell out if market sentiment plunges, the City watchdog has warned.

The Financial Conduct Authority issued the alert as bond funds continue to attract large sums from individual investors seeking a steady income.

Corporate bond funds invest at least 80% of assets in ‘investment grade' com­panies, which have a low risk of defaulting on interest and capital repayments. However, current and prospective investors are being urged to consider other risks if market conditions change or interest rates rise, which the Bank of England has signalled could happen in the months ahead.

Analysts at Barclays said the confluence of positive economic developments was ‘bad news' for bonds because it increased the likelihood of a rate rise. ‘Interest rate increases will put downward pressure on the prices of fixed-income securities, lead­ing to mark-to-market losses for bond portfolios,' they said.

The FCA is now warning about the effect of a rate rise on bonds, which could leave many investors nursing losses and spark a rush for the exit.

‘Interest rate movements have an impact on corporate bond and fund unit prices,' the watchdog said. ‘So, for example, as interest rates rise, bond prices fall. This is the key difference to deposit accounts, where the capital value is constant.'

Although fund managers aim to ensure investors can buy or sell their fund hold­ings on any day, there is concern they would be unable to sell enough bonds to meet redemption requests in a tough market environment, leaving investors stranded.

FT

Source: Dunkley, E. (2014) Watchdog sounds alarm over corporate bond funds, Financial Times, 29 July.

Liquidity risk (marketability risk)

If there is no active secondary market in the bonds it might not be possible to sell them prior to maturity.

Inflation risk (purchasing power risk)

This is where the purchasing power of money invested in the bond is eroded despite coupon and principal flows. This could leave a diminished positive real return or produce a negative real return, resulting in lower purchasing power than the investor had to start with. Inflation risk may also refer to the ensuing difficulty of selling an investment devalued through inflation.

Many companies have issued inflation-linked corporate bonds/notes (inflation- indexed or corporate inflation protected) paying coupons and principal which rise with inflation in a similar fashion to inflation-linked Treasuries (see Chapter 2). With some of these bonds the coupons are paid semi-annually. Others may pay interest monthly. Of course, the interest rate is usually higher than for government bonds due to the additional default risk. For example, in 2013 water company Severn Trent issued around £100 million worth of RPI-linked bonds in a ten-year sterling bond, offering a 1.3% annual coupon and a repay­ment of capital. Both the coupon and the principal will in line with the retail prices index. Investors were allowed to subscribe for as little as £2,000. This followed National Grid's ten-year RPI-linked issue, which raised £282 million from private investors, and Tesco Bank's offer of £60 million of eight-year bonds.

Reinvestment risk

This is the risk arising from the need to reinvest money received from a bond investment. For example, some issuers retain the right to redeem bonds at their insistence; bonds thus called may then leave investors struggling to find a replacement investment offering a similar rate of interest.

Call risk

There are three downsides for the lender when a bond agreement allows the issuer to buy them back from the holder before the normal redemption date:

1 Uncertainty regarding the cash flow from the investment because it is not known whether a call will be enacted.

2 Calls are likely to be exercised if interest rates fall, thus the investor faces reinvestment risk, i.e. buying other bonds at a lower yield.

3 A call provision will limit the capital appreciation potential of the bond because the price may not rise much above the price at which it could be called.

Supply risk

A company may issue further bonds of the same type, which could result in an over-supply in the market and the price falling.

Tax risk

A government might change its tax policy to the detriment of corporate bond holders.

Sector risk

Investors become unwilling to buy bonds in a certain sector (e.g. those issued by banks) regardless of the merits of an individual borrower, thus bond prices fall even for sound issuers.

Foreign exchange (currency) risk

Bonds denominated in a foreign currency have an uncertain value in the home currency if exchange rates vary.

Political risk

Bond values may be adversely affected by civil unrest, nationalisation of assets, inflation, government interference in markets, coups or dictatorships.

Company health risk

Corporate bond prices are often more closely linked to the health of the issuer than movements of interest rates within the economy than is the case for government bonds. Thus when general interest rates rise, a corporate bond's price may not go down as much as a reputable government bond of similar maturity because of the company's strong operating performance and/ or improving credit standing. Offsetting this benefit for a bond on a lower credit rating is that its price movements will be even more influenced by the company's health in terms of cash generation, financial structure and economic standing.

The issue process

Investment banks lie at the heart of the primary corporate bond market, with the expertise, contacts and reputation to advise on corporate finance and to organise the selling of bonds into the market. If the issue is relatively small a single bank will handle it, but larger issues are more likely to be underwritten by a syndicate of investment banks, especially if the bonds are sold in a num­ber of countries. Each syndicate member bank will be allocated a proportion of the issue to sell.

The process might begin with competing banks offering their services to the corporate. They will indicate the price/yield at which they think the bonds can be sold together with the size of their fees. The issuer will consider these factors along with the bank's reputation and standing. The bank that wins the mandate for the issue will be termed the lead underwriter, lead manager or book-runner. The lead underwriter will then usually team up with a number of other banks to simultaneously offer the bonds to the market. This syndicate often comprises banks from many countries. A co-lead manager(s) might be appointed to help sell the bonds in particular countries, where the lead man­ager does not have large client bases.

The usual method is the fixed-price re-offer. The investment bank syndicate agrees a fixed price and a fixed commission. It also agrees the quantity each member is to take to offer to the market at the agreed price. In this way the lead manager avoids the problem of some syndicate members selling the bonds at a low price in the grey market just to shift the bonds (‘dumping'). The grey market is the buying and selling of bonds before they have officially arrived on the market - they are traded on investors' anticipation of their allocation. The obligation to stick to a fixed price means that the lead manager does not have to step in to support the price by buying back the bonds.

In a bought deal the issuer is offered a package: a fixed price for a fixed quan­tity bought by the lead manager or managing group (not a syndicate). The issuer then has a few hours to decide whether to accept. If accepted the lead manager then either buys the whole issue to distribute to other investors or sells portions to other banks for distribution to investors - placement of the bonds. In anticipation of issuer acceptance many of the bonds will usually have been pre-placed with institutional investors (pension funds, insurance companies, etc.) before the bid was made. Obviously, bought deals are con­ducted by lead managers with large capital bases and with high placement ability; they might be left holding (‘wearing') the bonds if they cannot find buyers, thus tying up capital and damaging their reputation for accurately assessing market demand, pricing and marketing bonds.

Most corporate bonds are underwritten by an investment bank(s) on a firm commitment basis, meaning that the issuer is guaranteed a certain amount from the sale. However, some are best-efforts offerings where the bank(s) does not guarantee a firm price to the issuer, merely agreeing to act as a placing or distribution agent. A fee will be paid for this service. The downside of best-efforts issues is that investors are aware that the investment bank(s) has not committed any of its own funds and so they are usually unwilling to pay a price as high as they might with a firm fixed-price commitment from the lead underwriter.

The lead manager (often in cooperation with other syndicate members) will help the issuer prepare the prospectus to be presented to potential investors, detailing the issue and explaining the company and its finances. It will also deal with the legal issues and other documentation, using either an in-house legal team or an external one.

Fees as a percentage of funds raised for underwriting (agreeing to buy those not sold to the public) and selling bonds tend to be greater for longer maturities and for those lower down the credit rating scale, but smaller for large issues given the economies of scale.

When pricing a bond the lead manager often focuses on a benchmark bond currently trading in the market with the same maturity as the new issue and uses that as a reference. The new bond might be priced as so-many basis points of spread over or under the benchmark.

Private placements

In private placements an investment bank(s) uses its contacts to find finan­cial institutions willing to purchase the whole issue between them, usually no more than ten in the group. This allows the issuing company to develop a closer relationship with a tight-knit group of investors, first gaining under­standing of the business and later communicating progress, perhaps opening the possibility of raising more at a later date. Private placings also avoid the cost of obtaining and maintaining a credit rating for publicly traded bonds and the costs of additional disclosure.

In the US, where this market is very strong, privately placed bonds are un­registered with the Securities and Exchange Commission, with minimal dis­closure required, and so can be resold only to large, financially sophisticated investors; they are therefore not available to retail investors. Most privately placed bonds are 144a securities, meaning that they are exempt from SEC registration under Section 144a of the 1990 Securities Law. Private placement costs much less than a public offering because the issuer does not have to comply with generally accepted accounting principles and because marketing to only a handful of investing institutions is cheaper. A detailed prospectus does not need to be prepared; instead a much simpler private placement memorandum is sent to prospective investors.

Privately placed bonds tend to be illiquid and so are generally bought by institutions willing to buy and hold without going to the secondary market; interest rates tend to be higher to compensate for the illiquidity and because most of the issuers are less well known than for publicly placed bonds - the bonds are generally not ‘investment grade', i.e. with credit ratings under BBB-. Europeans are trying to grow a strong local private placement market - see Article 4.10.