From a top-down perspective, finding sources of investment income looks challenging.
By carefully and creatively looking at individual companies, we can uncover opportunities.
Examples of opportunities include lesser-known companies, companies in current difficulty but with potentially positive future, as well as opportunities uncovered by looking at different parts of a company’s capital structure.
With Federal Reserve policy as accommodative as it has ever been, today’s investors are frustrated because safe income isn’t high, and high income isn’t safe. Taking the top-down perspective one would usually see in the financial media, this frustration appears justified. U.S. Treasury obligations yield very little, while higher levels of income reside in security classes with intimidating names, like “common” stocks or “junk” bonds.
There are, however, instances where generalizations obscure the truth. Is pursuit of real income risky as we head into 2013? Probably not. But if we compare the universe of income investments to a forest, can we see what we need to see from a helicopter or a fire tower? Don’t be sure. It’s a very large forest. From far away, all the trees may look the same. There is no restriction, though, against taking a slow, methodical walk into the forest. As we do, we may find some sturdy, beautiful trees — that is, investment opportunities.
Despite significant gains in securities prices over the last few years, there remains a risk-averse tone to financial markets. Sometimes, investors are wary of lesser-known companies or industries where the current news is bad (even if history strongly suggests a better future). In other cases, a company may have issued securities that seem fairly priced, but other parts of the same company’s capital structure reflect concern and present opportunity. Here are some specific examples of these situations:
A disparity between debt and equity. One of the world’s most prominent telephone companies has been in business since the nineteenth century, and is a darling of the bond market. Its debt trades at narrowly higher rates than U.S. Treasury securities, causing the company’s intermediate-term obligations to yield less than 2%. At the same time, the company has been challenged by smaller, more nimble firms for the last 30 years, so equity investors are taking a very conservative view of the company’s future growth potential. As a result, the common dividend, which is covered by current earnings and expected free cash flow, is more than 5%.
Our current view is that this company’s dividend may grow slightly, and the probability of a reduction anytime soon is low. In our opinion, this company offers investors a choice between debt likely yielding below 2% over the next several years, or equity likely yielding more than 5%, with some of the “risk” to the latter forecast being that it is too conservative. Investment comparisons like this one are rarely discussed in newspapers or on television, but they can be very compelling.
Opportunity in one market sector that has proven successful in another. Food companies often sell at premium valuations in the U.S. equity market, particularly if they have unit growth potential. However, the food industry is concentrated and financially strong, which means that it may not be as familiar to investors in sub-investment grade bonds. An interesting bond was recently issued by a company specializing in kettle-cooked potato chips. Unit volume for this snack is growing faster than most other food categories; the company manufactures private label products for sale by a huge retailer and is a subcontractor to a major global snack food maker.
After some price appreciation, our potato chip maker’s new bonds still yield more than 8%, a level that seems very appealing given the growth potential and lack of economic sensitivity in the company’s business.
Struggling today but having a potentially bright future. There are always companies that are struggling now, but current and historical data suggest their future could be brighter. Most investors understand that such companies are likely to have depressed stock prices. But for income investors, it is depressed bond prices that are worthy of attention. For one thing, mere survival of the enterprise can lead to high sustained income and price appreciation for any bond bought well below face value. Secondly, there are various institutional constraints that force some investors to sell bonds at prices that ultimately prove to be too low.
When convertible bonds are not in default, but poor stock performance has reduced the conversion value to an unattractive level, disciplined and creative investors often see opportunity. An established coal mining company issued a convertible bond several years ago, when the economy was strong and energy prices were very high. Now, major end markets for coal, such as electricity generation and steel production, are flat. Also, the price of natural gas, an alternative fuel to coal for some uses, is historically low. For these reasons, investors can buy a convertible bond of this coal company for less than 50 cents per dollar of face value, despite a current yield of around 10% and a scheduled maturity in three years.
Owning this bond implies a great deal of uncertainty, because the demand and pricing for commodities like coal can be unpredictable. However, uncertainty of outcome and risk of capital loss are not necessarily the same thing. Perhaps 2015 will be a time of strong economic activity, with high natural gas prices caused by increased exportation and restrictions on fracking. In that case, investors in this convertible bond may well double their money, as the bond matures at par after paying a very handsome interest rate along the way.
A more challenging scenario would be the same backdrop we see today; that is, a dull economy and low natural gas prices. If this drove our coal miner into Chapter 11 bankruptcy in three years, it would be unfortunate, but maybe not disastrous. A buyer of this convertible issue at today’s prices could recoup more than 30% of the original investment in three years of interest payments. If asset value allowed for convertible creditors to get 35% of face value in bankruptcy — recall that the bond can be purchased for less than 50% of face value today — it is conceivable this investment would end up profitable.
Underlying this discussion is the assumption that the investor or investment manager carefully researches securities of all types, not just stocks. Test this assumption thoroughly before venturing into the approach described in this article with your money. At Columbia Management, we think a lot about the ever-changing investment forest. We also look at a lot of trees.
In general, equity securities tend to have greater price volatility than debt securities. The market value of securities may fall, fail to rise or fluctuate, sometimes rapidly and unpredictably. Market risk may affect a single issuer, sector of the economy, industry or the market as a whole.
There are risks associated with fixed income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer-term securities.