Shareholders are owners of a company by virtue of putting up the cash to run it, but a good business balances the sources of finance with the way it is used, and some of it can come from borrowing. A part of the borrowing may be a bank loan or overdraft, but to pay for major investments most managers reckon it is wiser to borrow long term. For some of this the company issues a different type of paper – in effect a corporate IOU. The generic name for this sort of corporate issue is ‘bonds’. They are tradable, long-term debt issues with an undertaking to pay regular interest (normally at a rate fixed at the time of issue) and generally with a specified redemption date when the issuer will buy the paper back. Some have extra security by being backed by some corporate asset, and some are straight unsecured borrowings. Holders of these must receive interest payments whether the company is making a profit or not. The specified dividend rate on bonds is sometimes called the ‘coupon’, from the days when they came with a long sheet of dated slips that had to be returned to the company to receive the payment.
Here as elsewhere in the book you will come across words such as ‘generally’, ‘usually’, ‘often’ and ‘normally’. This is not a cover for ignorance or lack of research but merely an acceptance of the City’s ingenuity. Variants of ancient practices are constantly being invented, and novel and clever financial instruments created to meet individual needs.
What is described is the norm, but investors should be prepared for occasional eccentricities or variants.
1. Permanent interest-bearing shares
The world of finance has its own language, with the problem that words are sometimes used in ways that do not tally with their everyday usage. It is not always intended to confuse the layperson – though it frequently has that effect – but specialist functions need specialist descriptions and even financiers have only the language we all use to draw on. One example is the difference between ‘permanent’ and ‘perpetual’. ‘Permanent capital’ is used as a label for corporate debt. ‘Perpetual’ means a financial instrument that has no declared end date. So a perpetual callable tier-one note sounds like a sort of debt but is in fact a sort of preference share. On the other hand, a permanent interest-bearing share is not a share at all but for all practical purposes a bond.
Permanent interest-bearing shares (Pibs) are shares issued by building societies that behave like bonds (or subordinated debt). Pibs from the demutualized building societies, including Halifax and Cheltenham & Gloucester, are known as ‘perpetual sub bonds’. Like other building society investments (including deposits) they make holders members of the building society.
They pay a fixed rate and have no stated redemption date, though some do have a range of dates when the issuer can (but need not) buy them back, almost always in the distant future. Sometimes, instead of being redeemed they are switched to a floating-rate note.
They cannot be sold back to the society but can be traded on the stock exchange. Not having a compulsory redemption date means the price fluctuates in line with both prevailing interest rates and the perceived soundness of the issuing organization, which makes them more volatile than most other bonds. If the level of interest rates in the economy rises then the price of Pibs will fall. If interest rates rise, their price falls, but if rates fall, capital values rise. There is generally no set investment minimum, though dealers will trade only thousands of them at a time, and stockbrokers’ dealing costs make investments of, say, under £1,000 to £1,500 uneconomic.
Pibs provided yields a couple of percentage points above undated gilts. With demutualization and the subsequent collapse of some building societies the yield has been forced higher to offset the risk. The risk is high because if capital ratios fall below specified levels, interest will not be paid to holders and since interest is not cumulative, it is lost for good. Another problem is that holders of Pibs rank below members holding shares (depositors) at a time of collapse, and, as they are classed as capital holders, are not protected by the Financial Services Compensation Scheme, unlike depositors who are protected for up to £85,000. However, building societies are generally low risk.
The good news is there is no stamp duty on buying these investments; interest is paid gross and though interest is taxable they can be sheltered in an ISA (Individual Savings Account); and, for the moment, they are not subject to capital gains tax. It is also worth bearing in mind that building societies, before greed carries them away into demutualization, are run conservatively, so their funds come mainly from savers rather than the much more volatile and unpredictable societies cannot be destabilized by having the redictable wholesale money markets. Having no quoted shares, building societies cannot be destabilized by having the share price undermined by specialized bear gamblers selling short (see Glossary).
2. Loan stocks and debentures
Bonds that have no specified asset to act as security are called ‘loan stocks’ or ‘notes’. These offset the greater risk by paying a higher rate of interest than debentures, which are secured against company assets. In Britain that is commonly a fixed asset but in the United States it is often a floating charge secured on corporate assets in general.
Interest payments (dividends) on these bonds come regularly, irrespective of the state of the company’s fortunes. As the rate of interest is fixed at issue, the market price of the paper will go up when interest rates are coming down and vice versa to ensure the yield from investing in the paper is in line with the returns obtainable elsewhere in the money markets. In other words, the investment return from buying bonds at any particular moment is governed more by the prevailing interest rates than by the state of the business issuing them.
The further off the maturity date the greater the volatility in response to interest rate changes because they are less dominated by the prospect of redemption receipts. On the other hand the oscillations are probably much less spectacular than for equities, where the price is governed by a much wider range of economic factors, not just in the economy but in the sector and the company.
Because the return is fixed at issue, once you have bought them you know exactly how much the revenue will be on the particular bonds, assuming the company stays solvent and the security is sound, right up to the point of redemption when the original capital is repaid. Since there is still that lingering worry about whether any specific company will survive, the return is a touch higher than on gilts (bonds issued by the government, page 11), which are reckoned to be totally safe. So for a private investor this represents a pretty easy decision: how confident am I that this corporation will survive long enough to go on paying the interest on the bonds, and is any lingering doubt offset by the return being higher than from gilts?
If the issuer defaults on the guaranteed interest payments – which is generally only when the business is in serious danger of collapse – debenture holders can appoint their own receiver to realize the assets that act as their security and so repay them the capital. Unsecured loan stock holders have no such option but still rank ahead of shareholders for the remnants when the company goes bust.
There are variants on the theme. A ‘subordinated debenture’, as the name implies, comes lower down the pecking order and will be paid at liquidation only after the unsubordinated debenture. Most of the bonds, especially the ones issued by US companies, are rated by Moody’s, Standard & Poor’s and other agencies with a graded system ranging from AAA for comfortingly safe down to D for bonds already in default.
3. Warrants
Warrants are often issued alongside a loan stock to provide the right to buy ordinary shares, normally over a specified period at a predetermined price, known as the ‘exercise’ or ‘strike’ price. They are also issued by some investment trusts. Since the paper therefore has some easily definable value, warrants are traded on the stock market, with the price related to the underlying shares: the value is the market price of the share minus the strike price.
They can gear up an investment. For instance, if the share stands at 100p and the cost of converting the warrants into ordinary shares has been set at 80p, the sensible price for the warrant would be 20p. If the share price now rises to 200p, the right price for the warrant would be 120p (deducting the cost of 80p for converting to shares). As a result, when the share price doubled the warrant price jumped six-fold.
This type of issue is in a way more suited for discussion under the heading of ‘derivatives’, alongside futures and options in Chapter 3.
Source: Becket Michael (2014), How the Stock Market Works: A Beginner’s Guide to Investment, Kogan Page; Fifth edition.
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