We look at the new corporate bond from Royal Bank of Scotland.
All investors soon learn that risk and return are two sides of the same coin. By chasing greater returns, you risk losing more of your capital. Likewise, by taking next-to-no risk and keeping your money in cash, you can expect very low returns.
The base rate has been stuck at a record low of 0.5% since March 2009. This makes it almost impossible to earn a positive return on cash deposits, after taking tax and inflation into account.
We yearn for yield
In their search for yield, many investors have piled into corporate bonds: IOUs issued by companies which pay a fixed income during their existence. In 2009, investor appetite for bonds saw sales of bond funds easily outstrip those of equity funds.
Growing consumer appetite for corporate bonds led the London Stock Exchange to launch its new Retail Bond market on 1 February. As this gathers pace, trading in retail bonds should become cheaper, simpler and more transparent.
However, investors need to understand that, although generally less risky and volatile than shares, corporate bonds are a great deal more volatile than cash. Indeed, bond investors face the following risks:
- Interest-rate risk: When interest rates rise, bond yields go up and, therefore, bond prices go down. With rates expect to rise in the years to come, now may be a bad time to bet on bonds.
- Credit risk: Buyers of corporate bonds lose out if the issuing company fails to pay each yearly coupon (interest payment) and the full face value of the bond when it matures.
- Liquidity risk: At times of extreme market volatility, you may even find it difficult to sell particular bonds. Finding a buyer may mean selling at a big discount.
- Market risk: In financial crises, fear can cause bond prices to swing wildly and fall rapidly.
The Royal Bond
If you buy a bond and hold it until maturity, then it will be redeemed at par (the face value) -- assuming no default, that is. Nevertheless, I would discourage private investors from buying just one or two individual corporate bonds, as this concentrates their default risk. Ideally, you'd want to buy several bonds, spreading your risk exactly as you would do with a portfolio of shares.
Bailed-out bank Royal Bank of Scotland (LSE: RBS) has seized on investor demand by launching its Royal 5.1% Bond. Here are this bond's details:
| Name | Royal 5.1% Bond |
| Ticker/EPIC | RB51 |
| Issue price/Redemption value | £100 |
| Coupon | 5.1%, paid yearly in February until 2020 |
| Minimum trade size | 1 bond |
| Duration | 10 years |
| Type of bond | Senior, unsubordinated corporate debt |
| RBS's credit rating | A+ from S&P |
| Trading | Listed on London Stock Exchange.
Can be traded in real-time via
stockbrokers during market hours |
| Tax situation | Income paid gross; any income tax
due must be declared and paid to
HMRC. No stamp duty payable. |
| Guarantee | 100% of capital returned on maturity.
Capital is protected at expiry only |
| Charges | Typical 0.75% bid-offer spread.
No early redemption charges. |
| Tax shelters | Eligible for inclusion in ISAs and SIPPs |
| Compensation scheme | Not covered by the Financial Services
Compensation Scheme (FSCS) |
If you're tempted, I'd highlight these four issues:
First, investors are urged to "Lock in 5.1% a year without locking away your capital." While investors can buy and sell the bond very easily, the only way to guarantee a full return of capital is to hold this bond until maturity in February 2020. Hence, I don't really like this promotional message. It may attract people used to fixed-rate savings account but who aren't fully up to speed with the additional risks that corporate bonds present.
Second, RBS seems to be playing on the fact that it enjoys tacit state support, being 84%-owned by the British government. However, this implicit guarantee cannot and will not last forever -- and is unlikely to be in force for the full ten-year life.
Third, in common with all corporate bonds, it is not covered by the FSCS scheme (which protects the first £50,000 per person of cash deposits). Therefore, without any government-backed safety net, this bond is far riskier than any savings account.
Fourth, when compared to other corporate bonds from financially strong issuers, the yield on offer appears to be slightly lower. For example, here are some UK corporate bonds traded on the new Retail Bond market which seem to offer slightly better value (although some are for longer than 10 years):
| Issuer | Coupon | Price | Maturity |
|---|
| GlaxoSmithKline (LSE: GSK) | 5.25% | 96.50 | 19/12/33 |
| National Grid (LSE: NG) | 5.785% | 102.35 | 02/02/24 |
| Tesco (LSE: TSCO) | 5.50% | 104.88 | 13/12/19 |
Each of the above companies has a strong business franchise and significant cash flows. I reckon this makes them good credit risks on par with a non-state-owned RBS.
All of the above bonds pay a higher coupon than the Royal Bond's 5.1%, making them more attractive to income-seekers. As you can see, their prices aren't £100, so the actual yield you'd receive if you bought them today will be slightly different from the coupon rate. The National Grid and Tesco bonds both trade above par and are therefore guaranteed to produce a capital loss if held to maturity.
It's worth noting that RBS issued a similar Royal Bond last year. Although this bond only had a life of six years, it offered a higher coupon rate of 5.3%.
Overall, I think I'll pass on this one. As the new Retail Bond market matures, I'm hoping we'll see some more tempting offers for income investors.
More from Cliff D'Arcy:
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