Are Tesco's 5% Bonds a Buy?

LONDON -- In the shape of its Tesco Bank operation, Tesco (OTC: TSCDY) (ISE: TSCO.L) has returned once again to the bond markets, intending to tap investors for cash.

And the reason is the same as with its two prior bond issues: to raise funds to increase the range of financial services and products that the bank offers to customers -- including mortgages.

Which is, presumably, good news for Tesco shareholders, speaking as it does to a growing demand for Tesco Bank's services.

But is the bond offering equally good news for fixed-income investors?

Nothing but the facts
The basics of the offer are simply stated.

  • The bonds pay a coupon of 5% and have a maturity period of 8.5 years, being repaid in full on Nov. 21, 2020.

  • Because that seven-year life exceeds the five-year minimum life laid down by HM Revenue & Customs, the bonds can be tucked inside an ISA and an SIPP, with that 5% income subject to no further tax.

  • The bonds will be issued at 1 pound with a minimum investment of 2,000 pounds. Higher amounts must be multiples of 100 pounds.

  • Income is paid twice annually, on Nov. 21 and May 21, with the first payment on Nov. 21, 2012.

Hold to redemption
Once launched, the bond will be traded on the London Stock Exchange's retail bond market. And over that time, its price will vary depending upon what happens to interest rates, inflation, and the world economy.

But the income paid will never vary: 2.50 pounds per 100 pounds invested, twice-yearly, until redemption.

At redemption, investors get their money back in full. Sell on the bond market prior to that, and what you get back depends on the price that day; you could make a hefty profit or an equally hefty loss.

If interest rates or inflation rise, expect the price of the bonds to go down as the fixed income they pay becomes relatively less attractive. If inflation or interest rates go down, expect the price of the bonds to rise.

Is your money secure? While your investment isn't covered by any FSA safety net, it will require a default -- or bankruptcy -- by Tesco Bank before your capital is threatened. That said, as the holder of "senior" bonds, you'll be ahead of shareholders and many other creditors.

Coupon versus dividends
Is the bond a buy? To me, this question revolves primarily around the reward that an investor gets for lending Tesco money, as opposed to investing in its shares.

Lend the company money and you'll get 5% a year, fixed for 8.5 years, irrespective of what happens to interest rates, inflation, or anything else.

Invest in the shares, and you'll almost certainly benefit from a rising dividend -- a dividend that already (thanks to Tesco's well-publicized travails) places the company on a prospective yield of 4.8%, tantalizingly close to the bond's yield of 5%.

Dividend growth
Back in the 1998-1999 financial year, Tesco paid a full-year dividend of 4.12 pence, and it has risen steadily in subsequent years. In fact, over the 14 years since then, this year's latest full-year dividend of 14.76 pence represents an annual growth rate of 9.54%.

Project this year's 14.76 pence dividend forward at that same growth rate of 9.54%, over the 8.5-year life of the bond and you get a final full-year dividend of 32 pence -- equivalent to a 9.8% purchase yield on today's share price of 325 pence.

The bond, meanwhile, carries on paying out 5%, year in, year out.

I know which I prefer.

Is that future dividend growth guaranteed, like the 5% coupon on the bonds? No, of course not. But if you believe, as I do, that Tesco's problems are temporary, then the shares beat the bonds hands down -- especially given the prospect of an increase in capital, thanks to an increase in the share price. Bond investors, meanwhile, just get their capital back -- unless they sell at a profit or loss before redemption.

Put another way, given Tesco's current prospective yield of 4.8%, the dividend -- and the share price -- would essentially have to go nowhere over the next eight years for the shares to be a worse bet.

Is that likely? I don't think so.

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At the time thisarticle was published Malcolm owns shares in Tesco.Motley Fool newsletter serviceshave recommended buying shares of Tesco. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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