Shareholders may feel like they’ve been on a roller-coaster. What about bondholders?
Bonds vs Equities: “I don’t like the equity, but should that put me off the bond?”
Whether we are talking to stock brokers or financial advisers, we often hear comments of “I don’t like that company” or “I wouldn’t invest in that company” when reviewing available XTBs. Generally, these comments reflect a view of the company’s equity rather than their bonds. This may be down to a bad past experience. Or perhaps, they have been tracking the equity and don’t like the fundamentals for the share price. They are generally not considering the company’s debt and their ability to pay the debt back in 1, 3, 5 etc years’ time. This view highlights a core difference in thinking between equity and bond investors.
Is owning debt the same experience as owning equity?
When you have shares in a company you are a part owner of the company. However, when you have debt in the company, the company owes you money.
If the company announces poor profit guidance, the share price can fall sharply. But, what happens to the debt? Does the bond price fall in the same way if they still have assets and are still making money, just not as much money? Remember, if a company needs cash they can raise money via new equity which the shareholder pays for. The bond holders don’t do anything, but the debt becomes safer once the company raises the cash – thanks equity holders!
Likewise, if the company experiences negative sentiment, such as being put under a microscope in the Royal Commission into Banking and Financial Services, how does that affect the equity compared to the debt?
What does bad PR do to bond prices?
An example of this is the recent performance of AMP, its share price has fallen following revelations from the Royal Commission and it has received a significant amount of negative media attention. We compare the total returns of the equity against the total returns of the AMP 4.75% 2021 senior fixed-rate bond.
CHART 1: AMP Equity vs AMP Fixed-Rate Bond
AMP equity fell around 32% in just over two months. Source: Bloomberg 16 Mar ’17 – 16 May ’18
The equity is the purple line and the bond is the teal line.
Volatility is very different between equity and bonds
Senior bonds in investment-grade companies like AMP are considered low risk assets. Chart 1 shows the low volatility of the AMP bond compared to the more volatile and riskier share price. Over this 18-month period, the bond has outperformed the equity at five different times. The recent Royal Commission and subsequent fall out saw the AMP share price fall from a high of $5.47 on 8 March 2018 to a low of $3.73 on 11 May 2018. This equates to around a 32% fall in just over 2 months.
How has the bond fared?
On the other hand, the same media attention has had little to no effect on the bond price. This is because, while the share market has concerns about the company and the subsequent effects on its revenue in the short to medium term, the bond market understands that AMP has assets and cash in the bank to pay off their debt in 2021.
For this reason bonds are often referred to as “sleep easy” assets. This demonstrates why it’s important to separate your views on becoming a part owner of a company (shareholder) versus loaning money to that same company (bondholder).
- Five steps to evaluate a company that issues bonds
- Balancing bonds and equities in a portfolio (video)
- Balancing bonds and equities for a perfectly blended portfolio