When it comes to investing in a company, we usually think about buying its shares. But many companies also issue bonds (loans) that investors can ‘buy’, too
Shares and bonds are very different in nature, however, and making an investment in one or the other is likely to have very different outcomes. This is why fund managers usually specialise in one or the other. However, some managers will consider both.
Neil Birrell, manager of the Premier Diversified Growth fund, invests directly in the equity and bonds of companies in his portfolio. “The underlying financial strength of a company, and its profitability, is at the core of any decision to invest in any part of a company,” he says.
“So when thinking about buying a bond or a share in a company, all fund managers will think about the risk and the potential return and make sure it is appropriate for the funds that they manage.”
Understanding the business cycle
Rhys Petheram, co-manager of Jupiter Distribution fund, attends company meetings with his co-manager Alastair Dunn, where they decide not only whether or not to invest, but if the investment would be best made via the company’s equity or debt.
“Key to our decision about investing in a bond or a share is understanding where the company is in terms of the business cycle, which we split into four phases,” says Mr Petheram.
“The first phase is ‘early-stage growth’. This is when both bond and shareholders can benefit. It could be after a recession or when the company has been through repair of some kind.
"The company’s shares and bonds are likely to be cheaper, therefore more attractive, the balance sheet is likely to be looking in better shape, and the company will be looking to finance its growth.
“Next is ‘later-stage’, which is more risky for bond investors. Business conditions are likely to be more challenging, management teams may be taking more risk and looking to spend money on mergers or acquisitions – which means they are taking on more debt. The share price could continue to climb for some time though, so equity investors are still positive.
“Then comes recession or a big ‘event’, not a good stage for shares or bonds. Risk of a company defaulting is higher, and there could also be a sell-off in its shares. Finally, we have the ‘repair’ stage, which can also be good for both.
"In 2008-2009 after the global financial crisis, for example, companies – especially the banks – focused on repairing their balance sheets. Risks are more easily identifiable and quantifiable in this stage.”
Will Mcintosh-Whyte, assistant fund manager on Rathbone Strategic Growth Portfolio, also cites the financial crisis as a source of new opportunities.
“The whole financial services industry faced increased regulation and had to strengthen balance sheets.
It was a regulatory-driven positive environment for bonds.”
While dividend cuts are seen as a negative for shareholders, they are not necessarily bad news for bond holders, he says. “You want to know a company will cut its dividend if it needs to – not just pay it regardless of its circumstances. Vodafone, for example, cut its dividend and sold assets to pay off some of its debt.”
While M&G Optimal Income is first and foremost a bond fund, it can invest a small amount in equities if manager Richard Woolnough thinks there are strong enough opportunities.
In the past decade his weighting to equities – which is limited to 20% of the fund – has been as low as zero and as high as 12%. At the moment the fund holds just under 5% in equities*, with holdings in Daimler, Santander, Adecco and American Airlines.
For Mr Woolnough, it’s about looking for the most attractive income stream in a company that he likes.
Usually it’s the bonds, but if the shares of the firm are providing a higher income than its bonds, and the added risk of investing in the shares is at an acceptable level for the fund, he may consider investing in them instead.
When it comes to investing in a company, there is certainly more to it than meets the eye.
* Source: fund factsheet, April 2019
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice. The mention of specific securities is for illustration purposes only and not a recommendation to buy or sell.