News Analysis: Companies switch from equity to debt

It may be an American import, but investors here are pouring billions into UK corporate bonds
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CORPORATE BONDS, an established method of finance for US companies, have become the latest American innovation to make it big on this side of the pond. In a marked departure from the past, barely a day is going by at the moment without some UK plc tapping the debt markets.

Royal Bank of Scotland, Lloyds Bank and Wessex Water are just a few of the big British names to have turned to this less traditional form of finance in recent weeks. The capitalisation of the Barclays All Stocks Sterling Corporate Bond Index rose from pounds 14bn in 1991 to pounds 100bn by the end of 1998 - an annual growth rate of almost 28 per cent.

Institutional investors can't get enough of these corporate bond issues. Recent research by the investment bank, Credit Suisse First Boston, calculates that UK institutions have been ploughing in record amounts. As the first chart shows, institutional investment in corporate bonds took off dramatically last year. Average investment per quarter topped pounds 4bn, far higher than the pounds 1bn per quarter that characterised the early 1990s.

Experts are reluctant to dismiss this explosion in corporate bonds as a mere fad, and say there are key influences of both demand and supply that should ensure that debt becomes an increasingly important source of finance for British business.

Phil Adams, an analyst at Barclays Capital, said: "There will be more and more appetite for, and more and more need to invest in, corporate bonds."

As far as institutional demand is concerned, the search for higher returns from investments has kick-started interest in the corporate bonds. Most analysts seem agreed that the world economy is moving into an era of relatively low inflation, an environment which typically favours bonds, not equities. Add to this the impact of the global economic slowdown on the outlook for corporate profits - and hence dividend growth - as well as the heady heights reached recently by some of the world's leading equity indices such as the Dow Jones, and it's not difficult to understand why over-reliance on equities is making investors nervous.

Doubts about the sustainability of equity returns typically prompt a surge in interest in UK government bonds, or gilts. Over the past year or so, however, as the second chart shows, investors' interest in gilts has tailed away to virtually nothing, for a number of related reasons.

To start with, the healthy position of the Government's finances has reduced projections for public borrowing and has meant that gilt sales over the next few years are likely to be far lower than the levels to which the markets have become accustomed. This drying-up of supply, combined with the jitters about equity returns and the general surge in risk aversion that accompanied the financial market chaos of last autumn, has pushed gilt prices sky high and sent yields to near-record lows.

The net effect of all this has been to prompt institutional investors to search out alternative sources of income. Corporate bonds fit the bill nicely. Their returns are relatively high, especially since last September's "flight to quality" widened the spread between yields on ultra-safe gilts and US Treasury bonds and other types.

The recent Barclays Capital equity-gilt study, an annual survey of asset returns, revealed that between 1991 and 1998 the real returns from corporate bonds averaged 13.15 per cent a year, marginally lower than the 13.47 per cent return on equities and significantly ahead of real gilt returns at 11.75 per cent. Even when adjusted for differing levels of risk, corporate bonds still consistently outperform gilts, according to the research.

Demographic change is another explanation for the booming institutional demand for corporate bonds. Gerald Holtham, chief strategist at Norwich Union Investment Management, said the post-war baby-boomers are now beginning to approach retirement age. The nearer their retirement, the more likely are policyholders to switch from more volatile investments such as equities to less volatile ones such as bonds. And the relative scarcity of government bonds means that corporate bonds, once again, are the investment of choice.

Mr Holtham said: "The popularity of corporate bonds is not just a fad. There are real structural factors behind it."

Demand has also been influenced by a number of government-led legal changes. Changes in the ACT rules for pension funds make it more attractive for the institutions to invest in bonds rather than equities. The surge in demand for corporate bond PEPs before they are replaced by ISAs this week has also been a contributory factor.

Changes in the tax regime have an impact upon the supply of corporate bonds, too. In particular, the abolition of ACT makes debt finance more tax-efficient for companies than equity finance. But perhaps the biggest factor behind the increase in corporate bond issuance is changes in institutional attitudes.

Institutional shareholders are less and less willing to tolerant inefficient uses of capital. UK companies, which typically are far less geared than their US counterparts, are under growing pressure to use their balance sheets efficiently.

Mr Adams said: "Traditionally, the UK companies have had less debt, and have been seen as more risk-averse than companies in the US. Now, however, that's all changing."

Institutional investors are also changing their attitude towards the UK stock market. Smaller quoted companies - in fact, most companies outside the FTSE 100 - are finding it more difficult to raise money on the equity markets, thanks to a range of factors such as the boom in tracker funds. So, rather than struggle with equity finance, a growing number of mid- cap companies are turning to the debt markets.

Record levels of issuance, record levels of institutional investment - there is no doubt that corporate bonds have caught on in Britain. And thanks to some fundamental shifts in demand and supply, corporate bonds - like many other US trends that have found favour this side of the Atlantic - look here to stay.