Over the course of the current (2015/16) financial year, I have built up a portfolio of 12 of the highest yielding Sterling fixed-income securities generally available to a retail investor. These securities are held in an individual savings account (Isa). This is important, as it means that all interest accrues free of tax. As at last night (March 14th), the portfolio offered a running yield of 9%, and a yield to maturity of 11%.
The 12 securities that make up the portfolio are as follows, in alphabetical order:
1. Balfour Beatty 10.5p convertible preference shares maturing 1/7/2020 (EPIC code: BBYB) with a yield to maturity (YTM) of 5.6% and running yield (RY) of 8.4% at the current offer price of 115.5
2. Co-operative Bank 11% subordinated loan notes maturing 20/12/2023 (42RQ): YTM of 8.4% and RY of 9.6% at current offer price of 114.75
3. Enquest Plc 5.5% senior bonds maturing 15/2/2022 (ENQ1): YTM 26.7% and RY 14.2% at current offer price of 38.65
4. Enterprise Inns 6.375% senior bonds maturing 26/09/2031 (AK44): YTM 6.6% and RY 6.5% at current offer price of 97.5
5. Eros International 6.5% senior bonds maturing 15/10/2021 (ERO1): YTM 18.8% and RY 11.1% at current offer price of 58.5
6. International Personal Finance 6.125% senior bonds maturing 8/05/2020 (IPF1): YTM 8.5% and RY 6.7% at current offer price of 92
7. Newcastle Building Society 12.625% PIBS (NBSR): YTM and RY both 7.25% at current offer price of 174
8. OneSavings Bank 7.875% Perpetual Subordinated Bonds (1SBB): YTM and RY both 8.75% at current offer price of 90
9. Premier Oil 5% senior bonds maturing 11/12/2020 (PMO1): YTM 15.8% and RY 7.7% at current offer price of 65
10. Raven Russia 12% cumulative redeemable preference shares (RUSP): YTM and RY both 9.7% at current offer price of 124
11. R.E.A. Holdings 9% cumulative preference shares (RE.B): YTM and RY both 10.1% at current offer price of 89
12. Skipton Building Society 6.875% PIBS (SBSB): YTM and RY both 7.1% at current offer price of 97.
The reason why these securities offer such tempting yields is because “the market” – that amorphous mass of buyers, sellers, speculators and investors – collectively believes there is a high chance that any of them might default. Their current yields thus price in a distinct possibility of capital loss.
The central proposition of High Yield Hypothesis being tested here is that, while individual high yield securities may indeed default at some point, the probability of loss for a diversified portfolio of such securities, over time, is likely to be less than implied by their market prices. Consequently, the returns that an investor can secure from high yield bonds should exceed that of other major asset classes.
The 12 securities listed above have been purchased in monthly intervals over the past 12 months at a total cost of £14,682, as described in monthly posts on this website. Alternatively, this investment of £14,682 could have been deployed into other assets:
1. Gilts, issued by the UK Government to fund its borrowing programme. The gilt that will be used in this test is the benchmark ten-year gilt, UK Treasury 4.25% maturing in 2027 (EPIC TR27). It is currently offered for sale at 127.38, giving the investor a running yield of 3.3%. That may not sound too bad for a security deemed to be “as good as gold”. However, at that price its yield to maturity is -1.8% because the investor will lose 27.38 when it is repaid at 100 on maturity. Public spritied though I try to be, I must confess that the prospect of being charged 1.8% per annum (i.e. the running yield less the annual capital loss through to maturity) does not fill me with any great joy. Yet gilts have actually been among the best performing of all asset classes during the 2015/16. Such is the crazy world that Central Bank policies of Quantitative Easing and financial repression has produced. The £14,682 investment could have been used to by £11,826 (nominal) stock in TR27 over the same period as the High Yield Portfolio was built up. At today’s prices, that stock would be worth £15,234, giving the gilt investor a 4% profit to date. We will see if the gilt investor is still in profit in five years’ time….
2. Gold. John Maynard Keynes may have described it as no more than a “barbarous relic”, but for many investors gold remains the ultimate store of value, accepted as such throughout the world, easily converted into cash, and a safe haven during periods of crisis and instability. In 2015/16, an investment of £14,682, committed on the same dates as the investments in high yield bonds, would have been sufficient to buy 19.42 troy ounces of gold, which would have risen in value to £16,876 as at today’s date. So gold bugs could feel quietly content at its performance this year. But gold generates no income, so its price would have to rise year by year by more than the yield on other assets in order to outperform them. The question is whether it can do so consistently.
3. The FTSE 100. Individual shares may rise or fall. Individual companies may collapse into insolvency. But the FTSE 100, the weighted index of the 100 largest companies by capitalisation quoted on the London Stock Exchange, will never default unless the entire economic system disintegrates. In which case we’d all have rather more important things to worry about. Moreover, the yield on a FTSE 100 index tracker, currently standing at 4.15% with the FTSE at 6150, is reasonably attractive in historical terms, particularly with inflation close to zero. It is a lot more appealing than the yield on gilts. An investment of £14,682 would have acquired 225 units in a FTSE 100 tracker at an average price of £65.25 over the course of 2015/16. This investment would currently be showing a loss, as some of the units were purchased when the FTSE was above 6900 in the quarter between April and June 2015. But over time, most investment analysts would predict on the basis of historical performance that equities will generate a higher return than either gilts or gold. My counter proposition is that, during a period of economic downswing such as we are currently experiencing, fixed-income securities may generate a higher and more stable return than equities.
4. Residential property. For many people in the UK, residential property is easily their single most important investment. To assess how it compares with the other asset classes, we will measure a synthetic index which assumes that an amount of £14,682 was invested in units of the Halifax House Price Index in 2015/16, when it averaged approximately 655. In addition, it is estimated that a net yield of 3% can be secured from rents on residential property, after all costs are met.
These then are the five runners in this particular race: high yield bonds, gilts, gold, equity and residential property. How they fluctuate over any short period will not tell us very much. Therefore, their performance will be measured over the five year period to March 31 2021 to determine the winner.
The starting cost of all five investments is £14,682. Gold is the current leader in terms of its value as at today’s date, followed by gilts. The question is how much each investment will generate in annual income between now and the end of March 2021, and what the terminal capital value of each investment will be on March 31 2021.
I will report the results here on that date, and also aim to provide an annual update in March of each year between now and 2021 on how each of the five asset classes is performing.
Let the race begin!
March 15th 2016