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Yield to less

Even rock-bottom basic stuff such as fixed-interest corporate bonds are a comparative rarity today. Only a trickle of such instruments comes to the market – seven such bonds specially for private investors were issued last year (although that included two UK government issues) and there have been just three so far this year. Yet of those issuers, the sole quoted company was Burford Capital (BUR), which – given that it’s a law firm – is a bit of an outlier anyway.

However, this week consumer credit provider International Personal Finance (IPF) was due to complete an offer of four-year fixed-interest bonds with a 7.75 per cent yield based on a coupon of the same amount and an issue price of ‘par’ (ie, £100 of nominal-value stock for every £100 paid).

For income-orientated investors that had to be appealing. After all, a 7.75 per cent yield is approaching twice the average dividend yield on the All-Share index and it’s close to the average annual long-term total return (income plus capital gain) that a sensible investor would target for an equity fund. So IPF’s offer prompts the thought: why bother with the risk of equities when you can have almost the same income via the comparative safety of a fixed-interest corporate bond? The answer is that corporate bonds come with their own risks, which impose penalties.

In the case of the IPF bond, the chief penalty is that not all of the 7.8 per cent yield can be used as income. At least it can’t unless an investor is prepared to see some capital evaporate because, when the bond matures in 2023, each £100 repaid will be worth less in real terms than £100 paid today.

How much less depends on future inflation, although the stock market value of similar bonds offers a clue. For example, Provident Financial (PFG), the UK consumer credit lender from which IPF was hived off in 2007, has a retail bond with a 5.1 per cent coupon that matures just two months before repayment of IPF’s new bond. Currently that bond trades almost at par, which means that both its running yield and its redemption yield (income plus the capital adjustment to redemption) are about 5.1 per cent. That provides us with a guide. It implies that the appropriate redemption yield for the IPF 2023 stock should also be about 5.1 per cent since it comes with similar risks.

Such a redemption yield indicates two things. First – and the good news – when the IPF stock starts trading, its price will rise to just over £110 because that’s the level at which its own redemption yield becomes 5.1 per cent. Second, and more important, investors who bought in the offer and plan to hold the stock to redemption should limit the income they take to a 5.1 per cent yield on the capital they invested while recycling the other 2.7 per cent back into their fund. That way, their capital gets preserved.

Meanwhile, back in the equity market, it was an understatement for me to say about security printer De La Rue (DLAR) that its cash flow for 2018-19 was less likely to cover the £25m cost of a maintained dividend than the previous year (see Bearbull, 24 May 2019). As it turned out, 2018-19’s cash flow was horrible, with a swing from a £63m operating inflow in 2017-18 to a £7m outflow. The main damage was caused by a £49m increase in trade receivables, although that figure excludes a slightly comical £18m provision for the inability of Venezuela’s central bank to pay its bill due to US sanctions.

More pertinent is to ask whether De La Rue is locked into a long-term decline that will eventually threaten its dividend; whether there is credibility in its bosses’ recovery plan; or, indeed, whether the company may be a takeover target, with its share price – currently 301p – languishing 65 per cent below its five-year high?

Certainly its bosses are sending mixed messages. They say that the five-year plan, ending next year, to “transform” De La Rue has made “good progress”. Yet perhaps not that good, since they have just instigated a three-year plan to cut £20m a year of costs by 2021-22. Just to muddy the waters further, they are getting shot of their chief executive, who has been in the job less than five years.

Perhaps all this is simply the hurly-burly of running a business in a messy and changing world – circumstances change and a company has to change with them. Alternatively, these may be the actions of a board that is making it up as it goes along. The trouble is, looking from the outside, it is always guesswork to assess which possibility is closer to the truth.

What is pretty clear is that 2018-19’s figures were dull – underlying revenues rose 12 per cent but operating profits dropped 4 per cent to £60m; cash flow, as just remarked, was horrible; and 2019-20 promises no better – the board says operating profit will be “somewhat lower” than 2018-19’s disappointing total.

So recovery isn’t in the offing, but it’s worth reminding ourselves that De La Rue is the world leader in printing both bank notes and passports. Both activities may be in long-term decline, but they won’t vanish. Meanwhile, De La Rue’s market heft gives it the opportunity to diversify into the electronic equivalent of passports and other forms of identification (both for people and products), which it is doing as rapidly as it can. Link these strategic advantages with the fact that here is a group whose annual revenues of £500m-plus on average generate profit margins easily clear of 10 per cent and you wonder why the market value of its equity has got down to little more than £300m.

That’s another way of wondering if De La Rue’s shares are a recovery play for the Bearbull income portfolio? It is tempting to say ‘yes’, especially as there is a 5.6 per cent yield on 2018-19’s final dividend alone. The shares don’t go ‘ex’ that payment until 4 July, so there is time for more thought. But I’m not convinced, although that may be me getting hung up on the messiness of De La Rue’s accounts, which makes it difficult to plug figures into models and get sensible estimates of underlying profitability and, therefore, possible value.

Besides, the income portfolio, which, so far, has had a good 2019, already holds one struggling recovery stock, touch-screens maker Zytronic (ZYT). To be more accurate, Zytronic is a growth stock that has morphed into a recovery play because trading has been poor and the performance of its illiquid shares worse. The consequence is that, at 237p, the share price is 55 per cent below its 12-month high.

True, I could have – perhaps should have – sold last autumn when the share price went through its stop-loss. That I didn’t had much to do with the fact that I had sold half the holding back in December 2015, in the process pocketing more than the original purchase cost. Thus, so the argument goes, the remaining holding has a theoretical cost of zero so any value remaining was always profit.

Frankly, I have always had doubts about such spiel. It’s better suited to stockpickers, who want to boast their success, than to investors whose need is to husband the value of a chunk of capital. After all, whatever profits might have been taken from a holding, a drop in the value of the remainder is always a loss to the portfolio.

Granted, I might not be discussing this if Zytronic’s share price had continued to rise. As it is, and calculated from the 2018 high point to the current share price, the opportunity loss from holding on is £14,500. More realistically, if I had sold at around the stop-loss level, I would have saved the fund a £10,000 paper loss.

Yet that loss may be made up since Zytronic’s shares, which in the past I have suggested looked expensive, now look decidedly cheap. Deduct the group’s £12m of net cash from the £38m market value of the equity and the shares trade at about seven times average net profits of the past five years. Okay, 2018-19’s profits will be below that average and it is likely to require an upturn in trading to get the share price moving – it would be especially useful if gaming companies resumed buying large-format screens in big numbers. Even so, implicitly the value is there – assess Zytronic on the basis of its accounting profits, cash flow, conversion of profits into cash, the strength of its balance sheet, employee productivity even, and the numbers all look good.

Meanwhile, the takeover of Manx Telecom has completed, so the income portfolio needs a new holding. I don’t have to rush because income received in the first half will be comfortably clear of 2018’s first half, and this year’s second half might even be up on the previous second half without investing the Manx cash. But happily there are a few possibilities, which we can discuss in the next week or so.


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