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Bond of the Week: 25 April 2012

Tesco Personal Finance bonds slip back a few points, incremental yield over gilts widens..... 

    

Investors have somewhat fallen out of love with Tesco. The grocer was one of the great growth stories of the UK market, but the share price peaked just below £5 in late 2007 and it has struggled to regain positive momentum thereafer. At £3.25, Tesco shares are now some 30% below the high.

Credit rating agency Moodys’ has also lowered its opinion of the company, downgrading Tesco’s credit rating from A3 to Baa1, citing increased competition and potentially lower margins. Should bond investors be concerned? I would say probably not. It may well be true that the company’s growth prospects have cooled, but we should view this in context. Tesco remains a large and highly profitable organisation (£3.8 billion for 2011) with relatively low levels of indebtedness (see link to last reports and accounts here).

What of last year’s new retail issue for Tesco Personal Finance, the banking subsidiary of the grocer? Although Tesco’s bank does not share the parent company’s rating, the Tesco Personal Finance 5.2% Aug 2018 bond has traded lower over the last month (see blue line on chart). This perhaps echoes the negative sentiment seen in the equity and is a noticeable divergence from the range trading behaviour of gilts.

It is also worth bearing in mind that the bank subsidiary has also released it own results (see link here). Profits are up 28.3% and impairment levels are down. This suggests a good outlook for Tesco’s bank, which is in the fortunate situation of being relatively new, and thus unencumbered with the type of balance-sheet horrors faced by its competition.

My view: Most private investors prefer to buy their bonds at par or below. The Tesco Bank 5.2% August 2018 bond stands at 105.5 (mid-price), which works out as a yield of 4.2% YTM. That’s still a premium, and this will dampen some of the demand. However, on a relative basis, the bond is good value. When launched, the bond offered an incremental yield of 2% over gilts of an equivalent maturity. This spread has now widened to nearly 3%, and I would expect the relationship to tighten back in over time.   

Mark Glowrey

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