No one can guarantee you anything in life. And that’s especially true when it comes to financial investments – they’re only ever promises written on bits of paper.
What we really need is to invest in the most reliable promises we can find. Not ones that just sound good!
So what makes a promise credible?
Today I’ll show you the four most important things that make a reliable promise (or financial investment, if you prefer). And we’ll look at a couple of investments you may want to consider.
Q1: What kind of promise have you got?
First and foremost you need a reliable contract. Part of my pension is in a ‘defined benefit’ pension scheme. Those are the ones where the company pays a percentage of final salary upon retirement. These are the best contracts you can get – that’s why companies have stopped offering them!
But other contracts are good too. Bonds, for instance – it’s why I keep telling you about them. If the business promises a coupon payment, then it’s darned well got to make it. Otherwise there are contractual penalties in place.
With equities, you’re a part-owner. Great. But you won’t see any benefits until all other commitments are made good. As far as reliability goes, these contracts aren’t the best. It’s why equities are volatile. As the business environment changes, so does the value of a company’s promise.
I’m not saying don’t hold equities, but I am saying that you should be aware of their limitations in terms of reliability.
Q2: Who are you lending to?
Having established the type of contract you’re in, you want to be sure that the guy standing behind your contract (or promise) is creditworthy.
Now, in recent times, government bonds have been given the status of ‘risk-free’. But this is just rubbish. Nothing is risk free. And we’re starting to realise that. From street sweepers to school teachers and doctors, they’re finding out that a government promise on pensions may not be all that it’s cracked up to be. Anyone with exposure to European sovereign debt will be painfully aware about the limitations on government promises.
When it comes to corporations, at least they can’t just change the rules as it suits. But which companies are most reliable?
Solid big businesses – yes, that’s an obvious place to start. But it’s not just big that counts. What really matters is financial stability, or balance sheet strength. The best way to assess that is by studying the accounts. How much has a business borrowed and on what terms? I haven’t time to tell you exactly what to look for here, but I’ll tackle it in The Right Side soon.
Of course the financial position of a business can change – so if the worst comes to the worst, then what security do you have?
Q3: Are they offering any valuables?
If the worst comes to the worst, we want to be certain we can get at least some of our capital back. Of course, that’s why a bank takes a mortgage over a property. If the financial circumstances of the individual change and they can’t keep up repayments, then ultimately the bank takes charge of the property.
That’s what I’ve got with my Enterprise Inns bond. Holders have a mortgage over a ring-fenced 500 pubs. Current valuation of the pubs is £1bn. Value of the bonds in issue is £600m.
I wouldn’t want to argue with anyone who tells me they don’t want to lend to Enterprise because its financial position may deteriorate. But I would suggest they’re only looking at half the story.
Incidentally, as an equity holder, you’re the last in the queue. I’ve held a few dogs that have gone belly-up in the past – never once have I got anything back after the receivers/administrators have picked over the bones and taken their fees.
That’s why you should be wary of using metrics like ‘book value’ when investing. Book value may not be a good indication of what you’ll actually get for the company’s assets in the event of liquidation.
Of course, the best thing is to never get involved with a business anywhere close to going bust. This is why you need to be sure of one thing...
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Q4: Can they really afford to cough up?
There’s no point in getting somebody to make you a grand promise if, by paying it, it drags the business down. That was the point I made against pensions minister Steve Webb’s grand ideas last week.
You want to be sure the issuer is in a good industry. It has to be one that can generate sufficient earnings to pay you back.
Now of course, a government is in a good industry – taxation! Generally they can pull in fresh money (or print it) to pay you back. I can see why some investors still love government debt. But there comes a point when even the government can’t tax its citizens more.
But what about businesses? Well, among the most reliable are utility companies. We’ll always need water, electricity, gas and telecoms. And what’s more, we’ll always pay the going rate for them.
Which is useful for the inflation-worriers among you. Depending on how the central planners deal with our debt crisis, we may need to tackle inflation at some point.
So it could be wise to have some inflation protection in place. And the most secure way of achieving that will be an index linked bond. That is a bond where the capital and income are guaranteed to rise above the rate of inflation.
Two bonds to consider
Now as it happens, at least two utility companies have issued index-linked bonds. And they’re available to buy through your standard stockbroker.
The recently issued Severn Trent RPI linked notes (LSE:SVTL) were released at £1 and you can buy them in the market today for a smidgen more. It will pay a real rate of interest (ie after inflation) of 1.3% a year for ten years, maturing in July 2022.
Last year National Grid offered a similar bond paying RPI plus 1.25% over ten years (LSE:NG1Q). For this one you’ll have to pay a little more in the market – it’s currently £1.02 to buy.
With RPI running at just over 3%, these bonds are returning around 4% for investors. Now that’s not bad... but it’s not great either. In absolute terms I much prefer my Co-op bond. But I know that some readers will prefer the promise of an RPI link, rather than a Libor link (with the Co-op bond).
If you are considering these bonds, you may want to sit on your hands for a while. The indications are that there are more bond issues in the offing.
If you buy into the new issue, you can avoid some fees and you’ll get in at par. Not all brokers are on the hot-list to deal in new bond issues, call yours and find out. And if I see a new issue that looks like good value, then I’ll be sure to let you know.
Bonds may sound boring, but if it’s a reliable promise you’re after, then they can be fantastic. And as part of a diversified portfolio, I’m convinced they’re essential.
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.
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