Are Tesco's Latest Bonds A Buy?

In the shape of its Tesco Bank operation, Tesco (LSE: TSCO) has returned once again to the bond markets, intending to tap investors for cash.

And the reason is the same as with its two prior bond issues: to raise funds to increase the range of financial services and products that the bank offers to customers -- including mortgages.

Which is presumably good news for Tesco shareholders, speaking as it does to a growing demand for Tesco Bank's services.

But is the bond offering equally good news for fixed-income investors?

Nothing but the facts

The basics of the offer are simply stated.

• The bonds pay a coupon of 5%, and have a maturity period of eight and half years, being repaid in full on 21 November 2020.
• Because that seven-year life exceeds the five-year minimum life laid down by HM Revenue & Customs, the bonds can be tucked inside an ISA and a SIPP, with that 5% income subject to no further tax.
• The bonds will be issued at £1.00 with a minimum investment of £2,000; higher amounts must be a multiple of £100.
• Income is paid twice annually, on 21 November and 21 May, with the first payment being on 21 November 2012.

Hold to redemption

Once launched, the bond will be traded on the London Stock Exchange's retail bond market. And over that time, its price will vary depending upon what happens to interest rates, inflation and the world economy.

But the income paid will never vary: £2.50 per £100 invested, twice-yearly, until redemption.

At redemption, investors get their money back in full. Sell on the bond market prior to that, and what you get back depends on the price on the day -- you could make a hefty profit, or an equally hefty loss.

If interest rates or inflation rise, expect the price of the bonds to go down, as the fixed-income that they pay becomes relatively less attractive. If inflation or interest rates go down, expect the price of the bonds to rise.

Is your money secure? While your investment isn't covered by any FSA safety net, it will require a default by Tesco Bank -- or its bankruptcy -- before your capital is threatened. That said, as the holder of 'senior' bonds, you'll be ahead of shareholders and many other creditors.

Coupon versus dividends

Lend the company money, you'll get 5% a year, fixed for eight and half years, irrespective of what happens to interest rates, inflation or anything else.

Invest in the shares, and you'll almost certainly benefit from a rising dividend. A dividend that already -- thanks to Tesco's well-publicised travails -- places the company on a prospective yield of 4.8%, tantalisingly close to the bond's yield of 5%.

Dividend growth

Back in the 1998-99 financial year, Tesco paid a full-year dividend of 4.12 pence, and it has risen steadily since in subsequent years. In fact, over the 14 years since then, this year's latest full-year dividend of 14.76 pence represents an annual growth rate of 9.54%.

Project this year's 14.76 pence dividend forward at that same growth rate of 9.54%, over the eight-and-a-half year life of the bond, and you get a final full-year dividend of 32.0 pence -- equivalent to a 9.8% purchase yield on today's share price of 325 pence.

The bond, meanwhile, carries on paying out 5%, year in, year out.

I know which I prefer.

No brainer