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On Friday, we looked at how to profit from the biggest non-event of all time.
The idea is that interest rates are set to remain low for the best part of three years. So far, the Fed’s talk of cheap money has been good for stocks and commodities. And that should continue.
But from where I’m sitting, a safer way of generating a good yield on our savings is with corporate bonds. And as promised, I’ve found another cracking bond deal for you today.
On a scale of risk, corporate bonds lie somewhere between cash and equity. Buying bonds, you take on a bit more risk than staying in cash. In return, you’re promised a higher return.
At the same time, as a bond investor, you’re not expected to take on the risks that equity holders face. That’s because when you buy a bond, your returns have been fixed in advance. The flipside is that we shouldn’t expect great capital growth with bonds.
The bond I want to show you today currently promises a yield of about 7.35% over the next three years. Not bad during a time when the Fed says returns are in lockdown. And I’d say that in this financial environment it’s a good looking return.
At the end of 2014, you’ll either get your capital repaid (having pocketed 7.35% pa), or the interest rate on the bond will be reset and pay out the benchmark gilt rate plus 4.375%.
Sounds interesting?
Let’s take a closer look...
A great way to get serious income for the next three years
You probably remember, life in the financial markets was very different before the credit crunch set in. Back then, an investor might expect to make a reasonable return. Even if he was conservative and wanted to stay in cash, he’d be expecting some useful interest.
So when in 2004 the insurance group RSA (Royal & Sun Alliance) wanted to borrow cash from these conservative investors, they launched a bond promising 8.5% pa over ten years.
Come hell or high water (and credit crunch too!) RSA has paid the interest on those bonds. And there are still three years to run on it – right up until 8 December 2014.
The great thing is, because this bond is traded on the London Stock Exchange, you can buy it (second-hand) in the market.
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The bond I’m recommending today is the RSA Insurance Group 8.5% Perpetual Subordinated bond.
Now I said above that it’s paying 7.35%. But as you can see from the name, the nominal coupon is actually 8.5%.
The reason the interest you’ll get is less than 8.5% is that the bond is trading a little higher than par (ie the initial launch price). This makes the yield a little less.
Come 2014, RSA has the option (but not the obligation), to redeem the bond at par. And in today’s environment, you’ll be happy to have been getting over 7% in the meantime.
But what if RSA don’t redeem the bonds in 2014?
You may have also spotted that the bond has ‘perpetual’ in its title. So although RSA may pay back the loan in 2014, it can in fact keep it running in perpetuity – that is, forever!
But, of course, a lot can happen between now and forever. So management wrote in a couple of clauses to mitigate risk. First they can repay the bond in 2014. And if they choose not to repay, they can repay on every five-year anniversary (ie 2019, 2024, etc, etc).
Second, if they choose to keep the bond running, then the interest rate will reset to 4.375% plus whatever the benchmark gilt is paying.
Now remember, back when this bond was launched, bond investors still wanted a decent yield. And 4.375% over the gilt rate is a handy return. Compared to other investments today, 4.375% looks pretty good.
Even if the benchmark gilt rate stays at today’s paltry 2%, then you’ll be getting over 6% on this bond (2% plus 4.375%).
And think about the potential advantage this offers you over more conventional bonds. With most bonds, there is no re-set. If you buy a 30-year bond (by no means uncommon) with a fixed coupon of 5%, then that’s what you’ll get for the next 30 years. Whatever happens to rates over the next 30 years, you’re stuck with your 5% interest rate.
But with the RSA bond, if interest rates storm upwards, then your interest will reset to 4.375% over the benchmark gilt.
Of course, RSA can always pay you off early, at one of the five-yearly reviews. But hey... at least you should get your money back with a good return in the interim.
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Some important risks for you to consider
As with any investment, it’s important to think about risks. I said earlier that I believe bonds are a safer bet than stocks. But they are not risk-free.
RSA’s history stretches back to the 18th century. It’s been around a long time and it’s grown into a massive global enterprise.
Being a financial company, it’s heavily regulated and needs to stick to certain capital requirements. That means it has to have a strong balance sheet. As of the last accounts, it’s got £1.3bn, which is more than double what the regulators demand. Just to put that figure into perspective, the bond issue (or loan) I’m talking about is for £450m. So, technically, RSA could pay this bond back immediately from its reserves.
But we shouldn’t be complacent. This is an insurance company, after all. They can have bad years, and may need to draw down on their capital buffer. Remember, too, that insurance companies hold massive investment portfolios. In this case, it’s got £13.5bn in financial assets (most of it in high-grade bonds). If the financial markets turn down, then it’ll eat into RSAs capital buffer. Put simply, a financial crash could tear into its balance sheet.
But looking on the bright side, during the 2008 downturn, RSA kept up interest payments on this bond. Even though, technically, it had the right to defer interest – that is delay payments so it could sort out its finances – it didn’t.
If it comes to it, it would be more likely that the equity holders take a hit. First dividends and then, if things are really bad, equity holders could be asked to pony up cash in the form of a rights issue.
Then again, if it does turn out really bad, the bondholders could suffer too. This is a ‘subordinated bond’ – that means that if the company goes bust, holders will be behind ‘guaranteed creditors’ in the queue when it comes to getting their money back. Ahead of shareholders, yes, but behind preferential creditors.
Three reasons I like this bond
All in all, I like this bond. It’s got some features that are useful as part of an overall diversified portfolio.
First off, it’s got almost three years to run, with coupons paying out over 7% pa.
Second, it’s got the potential of making holders more than 4% over the average government gilt in perpetuity.
Third, if RSA chooses to keep the bond running, then you’ve got the benefit of interest rate resets that keep your bonds tied to prevailing interest rates (albeit on a five-year review).
As with all the bonds I recommend, you can always sell them if you need to get hold of your cash. That’s more than can be said for much of the other fixed rate bond offerings on the high street.
But please do remember, you don’t get owt for nowt. There are no guarantees with these bonds. There’s undoubtedly more risk involved than cash in the bank, and if you wanted to sell your bonds in the market, you may not get back your full investment.
Overall, I’d say the risk/reward balance is in our favour with this one – especially when it’s part of a diversified portfolio. If you’ve got a bit of cash that you’d like to be paying you a decent fixed interest over the next three years, this could be a great option.
Action to take: BUY RSA Insurance Group 8.5% Perpetual Subordinated bond
In case you’re new to this, let me give you a couple of tips on buying bonds. Not all stockbrokers allow you to trade retail bonds. If yours doesn’t, check out MoneyWeek’s broker comparison page to find one that will.
And as with most of these retail bonds, you can only buy this one in multiples of 1,000 with a minimum investment of £1,000. You can get more information on the bond on the London Stock Exchange website.
RSA Insurance Group 8.5% Perpetual Subordinated bond
ISIN: XS0197028714
Currency: UK sterling
Current price: 104p
Minimum investment: £1,000
Further details: London Stock Exchange
Five-year performance: 2007 -2.12% | 2008 -29.08% | 2009 +10.08% | 2010 +6.35% | 2011 +18.35%
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.
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