the degree of risk of lending money to the company.
5. Inflation
We can also add to this list the risk of inflation, which can reduce the real value of any asset or portfolio over time. Bonds, with their fixed interest and redemption payments are particularly vulnerable to this risk.
Chapter 3: The players in the bond markets
A market is both created by, and exists to service, the needs of its users. In this aspect the bond market is little different from any other; and understanding the types of participants and the roles that they play is key to understanding how a market operates.
At the most basic level, the market consists of bond issuers – effectively the sellers of bonds – who need to raise capital. Set against this supply are the buyers – a wide variety of investors seeking a return on their capital. Between these two shades of black and white are many shades of grey. This chapter takes a look at the main players.
Issuers
If organisations did not need to borrow money, there would be no bond market. Thus Polonius’ oft-quoted advice from Shakespeare’s Hamlet [1] to “Never a borrower or a lender be” holds little sway in the industry. Major borrows have huge and repeating funding needs and tap the deep and liquid bonds markets on a regular basis.
Issuers range from sovereign governments, through huge multinationals such as BP or Unilever down to the medium size companies – FTSE 250 midcaps such as GKN or Enterprise Inns. All are seeking competitive sources of medium-to-long term capital. Issue size will vary from around £10 million (perhaps the smallest size possible) through to a typical £100-250 million issue and up to £500 million or £1 billion. Such block-busters are known as benchmark issues, generally liquid and transparent and useful points of reference for establishing relative value in the market.
Smaller companies are generally underrepresented in the corporate bond markets. The minimum practical deal size and the associated costs make the market unsuitable for such borrowers, whose needs are better matched by venture capital or bank lending.
Common sterling bond issuers
Well-known issuers in the sterling bonds markets include the following organisations. Bond investors should familiarise themselves with these borrowers. The issues of these organisations often become the benchmarks – large, liquid and well-known bonds against which other, possibly more interesting, bonds are valued.
The European Investment Bank
Europe’s state-owned development bank, the EIB, was established in 1958 after the Treaty of Rome and was the first of the European Union’s financing institutions. Its shareholders are the 27 Member States of the Union, which have jointly subscribed its capital. The EIB’s Board of Governors is composed of the Finance Ministers of these States. The EIB’s role is to provide long-term finance in support of investment projects.
The EIB is a regular participant in the sterling bond market, issuing a range of maturities, effectively shadowing the structure of the gilt market with a range of bonds offered across different maturities.
Kreditanstalt für Wiederaufbau
The German government-owned development bank, KFW, is based in Frankfurt and was formed after WWII as part of the Marshall Plan to rebuild the then shattered Germany. Effectively a German state credit. The bonds are AAA-rated and trade tightly to gilts. As with all large financial organisations, KFW raises finance across the international financial markets, including the sterling bond market in order to better diversify its funding base.
UK banks & building societies
Banks are typically the largest users of the bonds markets both as issuers and as investors. Banks raise different types of capital and funding in the markets. This results in a variety of different types of bank debt, ranging from senior (ordinary) through to subordinated bonds (a higher risk and higher yielding type of debt – more on this later). The sterling market is notable for the high number of subordinated issues from these issuers.
Some investors, notably the banks themselves, have historically viewed bank debt as the “next best” credit after government and government agency debt. This perception of the quality of bank debt has weakened considerably following the events of the credit crunch, with investors preferring bonds issued by other sectors. It remains to be seen if the conventional pecking order will be restored.
Tip
When buying bank or building society bonds, double check the seniority of the issue. Subordinated bonds are a less secure form of debt. These have their place, but are a somewhat different kettle of fish to senior debt – higher risk, subject to coupon deferral and much more volatile. Risk is fine, but as investors we will expect to see a higher return to compensate.
General Electric
The giant US engineering and financial services conglomerate. Often judged to be a financial sector company rather than a true corporate (the company derives around half its revenue from financial services). GE has a balance sheet the size of Jupiter and the company’s bonds typically show correlation to bank debt. GE has a systematic program of issuance into the sterling bond markets and they have bonds trading at a wide range of maturities.
Utilities
Utilities such as National Grid and Severn Trent are frequent issuers into the UK market. The low-risk nature of the utility business makes such issuers a popular choice for the typically risk-adverse bond investor.
Tesco
One of the UK’s biggest companies and a frequent issuer on the GBP (and other) bond markets. In 2011 Tesco Bank (a subsidiary) issued a sterling bond into the retail market and has a pipeline of such issues planned.
The above examples are simply some of the most well-known issuers of sterling bonds. Further research will yield a list of hundreds of other issuers and their bonds. Often, the less well-known the issuer, the more interesting (and potentially undervalued) the bond.
Tip
keep an eye open for bond market debutantes. Bond issues from new or unknown issuers often have to be priced to sell – great for “stags”.
You can find a table of popular sterling bonds in the appendix at the back of this book. Please note, this represents only a sample of a wider market. Liquidity and transparency are moveable feasts and this, combined with the inevitable process of redemption and new issues will make the list look quite different a few years down the road.
Investment banks
It is fair to say that investment banks (IBs) are the bond market. The reverse is also true; the bond market consists of investment banks. A study of the results of the major players such as Goldman Sachs, or the late Salomon Brothers or even our own domestic operators such Barclays Capital, show that it is in bonds
