A tale of two journeys for bond and equity holders

It is uncontroversial to say that the typical Australian investor is more familiar with investing in shares than bonds. Many investors accept the gyrations that are part and parcel of investing in shares and yet are cautious about what experience may meet them in the bond market. This is largely due to the fear of the unknown, which is understandable to an extent. Hopefully what follows clears some of the fog around the experience you could expect when investing in the bond market.

Bonds sit higher up the ‘capital structure’ of an organisation than shares, meaning that bondholders have a priority claim on assets ahead of shareholders in the event of liquidation. However, the risk of bonds versus shares depends on various factors including issuer creditworthiness and market interest rate risk and is best illustrated in the diagram below.

 

In the event of a company being wound up, shareholders, as owners of the business, are in the first loss position. At the other end of the spectrum senior secured debt holders are unlikely to incur losses, if the lending has been well collateralised. Needless to say, that the market understands this and prices the risk of each very differently.

Given their higher priority in the capital structure, senior secured debt holders accept a lower and more stable and predictable return. As long as the issuer of the bond is not in administration when the bonds mature, bond investors should seamlessly get the face or security value of their capital back. The journey for equity holders will be much less stable and predictable which can be both a good and/or bad thing.

As much as some of my fellow bond acolytes might use this to suggest that bonds are better than shares, the reality is that they are simply different. Bonds appeal to different investors with a different set of risks and risk tolerances. Stereotypically bonds appeal to more risk averse, income seeking investors whereas equity investors are more focused on growth. Ultimately, I believe that there is room for both in most investment portfolios and one’s weighting to each will come down to a number of factors including your risk tolerance, age, need for income, desire for capital growth etc.

One question I often face is ‘surely if a company is under considerable financial pressure, that is bad news for both bond and shareholders?’ Particularly for anyone other than well collateralised senior secured debt holders. WA based mining services company Mineral Resources (Minres) has provided an ideal case study for this situation over the last year or so.

Minres has a number of ‘senior unsecured’ bonds in the market. Senior unsecured means that the bond is not secured against a specific asset, it is secured against all the assets of the company that are not subject to a secured charge. As such it sits halfway up the capital structure (as per diagram above). For me, this is often where the best trade-off between risk and return can be found.

The chart below reflects the journey that Minres bond and equity holders have been on over the last three and a half years. It shows a starkly different experience. Bond holders need the company to survive and continue to meet its debt obligations to get their capital back. Note the maturity dates of the bonds range from 2027 – 2030. The capital value of each of the bonds has been very stable and remained consistently above the issue price of 100. It is also worth noting that Minres is a high yield bond and as such you would expect it to exhibit more capital volatility than you would see from an investment grade bond. In addition to this capital stability bondholders have enjoyed a healthy income stream of 8% - 9.25% per annum depending on the bond they held.   

On the other hand, shareholders have had a very bumpy ride. Initially it was volatile but broadly sideways; however since around May last year the shares have fallen precipitously, from almost $80 to just above $20 today. Minres has faced some well documented challenges which has caused this drop, however despite the seriousness of some of the issues the bond market is shrugging it off.

The bond market is clearly cognisant of the difficulties however it is taking the view that this is not a life-or-death battle for Minres. Bondholders expect the group to survive which should allow them to get their capital back when the bonds mature. The outlook for shareholders is much less certain. Minres can survive but that doesn’t automatically mean that shareholders will thrive even from the current low valuation.

Hopefully for those who are unfamiliar with bond investing this might help give you a better idea of the experience that may lay ahead. This is a relatively extreme example however it is illustrative of the benefits of being higher up in the capital structure, particularly at a time when a company is under severe pressure.