Who’s afraid of the big bad bear?

An air of despondency hangs over the City of London, with security markets in steady decline, dragged down by the collapse in international commodity prices. In Aberdeen, Britain’s oil capital, the atmosphere is closer to panic. Property prices are tumbling, and many who want to sell are finding no buyers at all. In late January, the Financial Times reported that “oil rigs stand idle in the Cromarty Firth near Inverness, where freezing waters have been a gauge for the chilling effects of the big fall in oil prices.” The FTSE is officially in bear territory, having fallen more than a fifth from its peak of 7,100 last April to less than 5,500 at one point in February.

This is further confirmatory evidence, if such is needed, that the UK economy, along with most of the OECD, is in a long economic downswing. As I wrote in The Golden Guinea in 2012, “the weak stock market recovery between 2009 and 2011 was a secondary reaction within a prolonged bear market, rather than the harbinger of a sustained recovery” (p. 202).

Does this mean that now is the time to liquidate holdings of all financial securities? I would say not: if one listens to the advice of successful investors through the ages, bear markets represent an excellent opportunity to build up security holdings. Baron Rothschild advised that, “the time to buy is when there is blood on the street, even if the blood is your own.” Sir John Templeton recommended that an investor should “buy at the point of maximum pessimism.” I don’t know whether we are at the point of maximum pessimism now, but we are certainly not at the point of maximum optimism. And Warren Buffett advised, “keep things simple, by accumulating securities over a long period, and never sell when the news is bad and their prices are well off their highs.”

But the question is – what securities to buy? It is my contention, as set out in previous comments on this website, that during a long economic downswing bonds represent a superior investment to equities.

Within the entire class of fixed-income securities, I am testing a further hypothesis. This is the hypothesis that fallen angels – bonds which have lost their investment-grade rating, whose prices have fallen and yields have risen – represent, as an asset class, better value than gilts or investment-grade corporate bonds.

This hypothesis is being tested by building up a portfolio of 12 sub investment-grade fixed-income securities, buying one in each month of the 2015/16 financial year. There are currently 11 securities in the portfolio, with the final security purchased today. This is the convertible preference share issued by Balfour Beatty, paying a gross dividend of 10.75 pence per share, which equates to a net dividend of 9.675 pence per share after a 10% tax is deducted at source.

The yield to maturity, at just under 6%, is the lowest on any of the 12 securities in the high yield portfolio. Against this, the preference shares offer potential upside as they carry the right to convert into Balfour Beatty ordinary shares at a conversion ratio of 0.2469136 ordinary shares per preference share.

In my quieter moments, I do wonder how many hours of billable time was spent by some financial wizard to come up with this exact conversion ratio, as opposed to, say, a ratio of 0.25 ordinary shares per preference share. But of course that would have been too easy and no fun at all. Even worse, such a simple conversion ratio would doubtless have generated far lower advisory fees and, horror of horrors, been readily understandable to the ordinary investor.

Be that as it may, it can be calculated that it would be worth converting the preference shares into ordinary shares on maturity in July 2020 if the price of the ordinary shares exceeds £4.05 on that date. Admittedly, this doesn’t look very likely at the moment, with Balfour Beatty shares trading at a price of just £2.30, but given the volatility of stock market prices it is by no means impossible that the price of the ordinary shares rises by more than £1.75 over the next four years.

So the Balfour Beatty convertibles become the 12th and final security acquired for the Experimental High Yield Portfolio.

Issuer: Balfor Beatty Plc
Coupon: 10.75% gross, equating to 9.675% net after a 10% tax deduction
Maturity Date: July 1st 2020
Conversion Rights: 0.2469136 Ordinary Shares per 1 Preference Share up to the date of maturity
Payment Dates: 6-monthly on January 1st and July 1st
Offer Price: 114.35
Running Yield: (at Offer Price) 8.5%
Yield to maturity (at Offer Price): 5.9%
Nominal Amount: £1,000
Cost £1,143.50 + £13.67 commission and stamp duty = £1,157.17

February 16th 2016

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