Three promising bond buys
Chris Bowie, head of credit at Britannic Asset Management, tells MoneyWeek where he’d put his money now.
As yields and yield volatility fall, making money from investment-grade corporate-bond portfolios in 2006 is difficult. It means you should only take positions if you are convinced the bonds will do well. Here are three that have convinced me.
General Motors is in structural decline. The company is losing market share to Asian manufacturers and, rather than improving its product range to compete, it’s buying market share by almost giving its cars away. It also has problems with its pension deficits, healthcare liabilities, and its product range, which is too broad. The outlook is bleak. These concerns have driven spreads to stratospheric levels, with long-dated GM debt offering spreads of 1,000 basis points over gilts – a total yield of 13.5%!
But that doesn’t mean that GM bonds should take their place in a traditional diversified investment-grade bond fund: there is too high a risk of GM filing for Chapter 11 bankruptcy before 2015 – when the bonds mature – which would lead to a default on its bonds. But December 2007 GMAC bonds (the financing arm of General Motors) most certainly do offer value. They have widened in sympathy with GM debt, taking spreads to 500 basis points over gilts with a total yield of more than 9%.
Remember that GMAC is a totally different investment proposition to GM: it generates positive earnings and positive cash flow, and it is up for sale. In addition, GM’s healthy $20.5bn cash pile means that it should comfortably be able to repay par on these bonds at maturity in less than two years. If between now and December 2007 GMAC is sold, a healthy spread contraction measured in hundreds of basis points is likely. And these bonds are generating a very nice level of income.
Since Resolution’s debut in the sterling market in November 2005 at a spread of 208 basis points over gilts, the spread has widened by 15 basis points. Opinion is divided over whether this is a risky investment, or a sensible one at a decent spread.
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I take the latter view: future acquisitions will enhance the firm’s earnings potential and the embedded value of the group. There is risk, but I have complete faith in the management to deliver profitable growth with an internal rate of return on future acquisitions at the well-publicised hurdle rate of 12% after tax. With that in mind, a yield of more than 2% over gilts is very welcome, and hard to find elsewhere.
Boots is a firm we don’t own yet. But its problems are not insurmountable. In my view, the company needs to boost its earnings potential by beating the supermarkets at their own game and acquiring a high-quality property portfolio. But that would require a change of management. In this case, that might involve a leveraged buyout.
Typically, leveraged buyouts (LBOs) are bad for bond investors because the additional leverage used to finance the transaction worsens the debt/equity profile. In a general sense you would expect that to be the case here too. However, the short-dated nature of the bond in question (May 2009) means that a restructuring negotiation could well involve the early repayment of this bond. That may be very good for bondholders.
But don’t buy in just yet. Right now, the bond is just too expensive, yielding only 70 basis points over gilts. Pricing in the risk of a leveraged buyout would require a three-digit spread. If it widens out that far we may well take some exposure, but not until then.
