Assessing the comparables between these two popular asset classes
Private investors have historically most commonly built their portfolios around stock market-listed equities. At the end of 2014, circa. 12% of all equity listed on the London Stock Exchange was owned by UK-domiciled private investors. The total value of that holding equates to around £206 billion. However, the retail corporate bond market is growing fast, with £1 billion invested into bonds listed on the London Stock Exchange’s Order Book for Retail Bonds (ORB) in 2013. As well as the kind of listed retail corporate bonds on ORB, mini bonds also represent a quickly growing market. In 2013 the value of the UK’s mini bonds market was put at £90 million. Capita Registrars, a company which specialises in the launch of this kind of bond, expects the mini bond market to also grow to an annual £1 billion value over the next several years.
So what is it that is attracting private investors to allocate at least part of their investment capital into bonds? Investors primarily look at a handful of key comparables when weighing up their investment options. So how do bonds stack up against equities in that context?
Return on Investment
The strength of equities and the problem with equities, in almost equal measure, is that it is close to impossible to accurately predict the returns they will bring. Yes, you can pick a winner and make 20% almost overnight but you can equally as easily pick a dud that plummets in value. Big blue-chips tend to be less volatile and can offer income from dividends but these companies also regularly gain and lose big chunks of value over the course of months and years. Professional and private investors alike combat this volatility by building diversified portfolios. However, as a result, gains tend to be a modest average of somewhere around 5% for well-balanced portfolios with a very small number of equity investors, professional or otherwise, consistently beating the market. It’s certainly possible to outperform the return on investment offered by bonds through equities but all historical evidence points to this being hard to achieve for most. A strength of equities over bonds, however, is that holders can realise both income from dividends as well as capital gains if the value of the equities rises.
Bonds typically offer fixed interest returns, meaning that the investor knows exactly what return on investment they will realise from the investment. This tends to sit within a range of 4% to 9% depending on the market’s perception of the level of risk of default. There are very few equities investors, even amongst the highly paid professional fund managers, that can consistently show comparable returns from equities over a 10-year period. Exchange-listed bonds can also increase and decrease in value depending on demand, though the typical extremes of fluctuation are generally far tighter than is the case for equities. This is because the returned value at the point of maturity does not change from the original purchase price.
Liquidity is where equities come into their own and have a clear advantage over any other kind of asset class other than cash equivalents. All but the very biggest holders of listed equity in a company can almost instantly sell their stake at the current market price during the stock market’s opening hours. Even holders of extremely large equity stakes can sell them off within a relatively short window of time should they wish to. This means that investors can both convert their equity investments into cash should they wish to as well as being able to crystallise profits or cut their losses when they choose.
Exchange-listed corporate bonds such as those listed on ORB can also be sold easily and are considered a liquid asset. However, liquidity levels are still nowhere near those of equities so especially larger holdings can potentially take some time to be matched with a buyer.
Non-listed bonds, however, are an illiquid asset. While they can often be returned before the date of full maturity this is generally permitted only at certain defined junctures, often the anniversaries of issuance. There may also be a penalty attached to early redemption, particularly within the first year or two of the bond’s lifetime.
Stock market-listed companies are subject to heavy regulation as are intermediaries and proxies who may hold equities on account for their clients. While the market value of equities can be volatile there is little risk of investors losing the stock itself. They will always be able to cash equities in when they choose, even if that is at a loss. Listed companies also have to publically publish their accounts so investors have access to full information on their financials and can make judgement call on their ongoing prospects on that basis. The primary risk inherent in equities investment is in their potential to lose significant value over a short space of time.
Bonds embody an inverse risk profile. The value of the investment will not change from the terms laid out at the time of the bond’s issuance. With bonds, the risk lies in the potential of the issuing company to fail or to not have sufficient cash flow to cover the commitments of its debt. While bonds will be theoretically underwritten by the company’s assets, there is no guarantee that these will be sufficient to cover all debts in the case of it running into trouble. If the bond is issued by a non-listed company, investors will also not have the same access to the company’s financials upon which to base a judgement on its likely and ongoing ability to honour the bond’s terms.