Market View

The return of the coupon

bond yield
Jeremy Sterngold, Head of Fixed Income

Throughout most of the year, a large part of the focus of these publications has been on inflation and central bank activity. The sharp increases in price pressures over the past year, exacerbated by Russia’s war in Ukraine and its resulting sanctions, has seen the hawks in the central banks strike back. We have seen the Federal Reserve (Fed) opt for two back-to-back, supersized 0.75% hikes, and both the Bank of England (BoE) and the European Central Bank (ECB) opt for 0.5% hikes. Given that the Fed was still buying Treasuries during the first quarter of this year, moving rates this swiftly while attempting to reduce its balance sheet has caused enormous gyrations in both bond and equity markets. While both markets suffered large drawdowns during periods of this year, in the case of bond holders (investing in quality paper) when total returns are negative, this typically means that yields or expected return to maturity has risen.

At the end of last year, two year US Treasury and Gilt yields were at 0.73% and 0.69% respectively. Fast forward to today (at the time of writing), these now stand at 3.25% and 2.55% respectively. These levels do provide investors with a solid level of income, but investors may still be concerned that central banks will continue to raise rates even further resulting in mark to market losses. While that is an understandable concern, it is worth bearing in mind that shorter dated bonds primarily serve the purpose of delivering an income for investors. Given the now prevailing market rates, this means borrowers coming to the market have to offer a much higher coupon. A good example of this is looking at the US dollar bonds that Pepsi issued over the past year. In October last year, when Pepsi sought financing for ten years, it was able to issue those bonds with a coupon of 1.95%. However, when it came back to the market in mid-July, it now had to pay 3.9% for a similar term. While we can clearly deduct that the CFO of Pepsi clearly wished he borrowed more last year, for investors having a high coupon, or existing lower coupon bonds trading at a discount to offer a similar yield, this means investors will have a greater cushion before they suffer losses on total return basis over a twelve month period in the face of potentially higher yields.

Looking at a more domestic example, the outstanding debt of Tesco paying a coupon of 2.5% and maturing on the 2nd of May 2025, is currently indicated to offer investors a yield of around 4.5%. So let’s assume we hold this bond for one year from today, how much does the yield of the bond have to move by before investors experience a loss on total return basis. Applying bond maths, something an experienced fixed income investor, albeit perhaps nerdy always enjoys doing, tell me that the yield on the bond has to move in excess of 6.25% over that twelve month period to lose money on a total return basis over that period. To me that sounds likely a compelling investment in the current times of market volatility. Investors holding it to maturity, can expect to receive an equivalent of annual return of 4.5% for the remaining 32 months. Albeit not as high as the current rate of inflation, and not likely to beat it over the next twelve months, when inflation does cool after that, the return available on corporate bonds may not be quite a generous as they are today. So, while there remain a lot of headlines about how far central banks will raise rates, the hawkish rhetoric and string of rates hikes have brought a new hope for income seeking investors with the corporate bond market offering some good select opportunities.     

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