How companies are funded and what the capital structure means for you
The capital structure of a company can be very complex from a legal perspective, but is crucial for investors’ understanding of the risks they take when making investments. In this article we break the capital structure down into its component parts and give examples of the types of investments you can make in each area.
In bull equity markets, such as the one we are in, it is easy to become complacent about the risks you take in making investment decisions. It is usually only when the tide turns, when stock markets fall and bond yields spike, that investors really start questioning what they are invested in.
The way in which companies finance their day-to-day activities allows investors to gain exposure to different parts of their capital structure, primarily equity and debt, and therefore to manage the risk they take. In the image below we show the seniority of the capital structure, which dictates firstly how a company funds its operations and secondly the order, in which investors stand should the company fall into financial difficulty.
At the top of the capital structure sit bank loans, which are secured by company collateral, followed by unsecured debt, preferred stock, and finally common stock (or equity). Due to the relative risk that investors take in funding companies, bank loans should have the lowest cost of capital, followed by bonds, and finally equities, where the holders will see the value their shareholding fall to zero in the event of a bankruptcy.
Capital structure of a company
Source: IG, June 2017
In the paragraphs below we summarise the types of investments available in each tier of the capital structure.
Senior secured debt
This sits at the top of the capital structure, and is the first area to get paid in the event of a company defaulting. Typically it includes floating rate notes issued by banks, and bank debt.
US investors can get exposure to senior debt through exchange traded funds (ETFs) such as SPDR Blackstone/GSO Senior Loan ETF (SRLN) and PowerShares Senior Loan Portfolio (BKLN), but it is noticeable that iShares do not have an offering, which is likely to be due to the illiquidity of the asset class. These types of loans tend to trade off exchange, and in times of stress there may be few buyers.
UK investors looking for a GBP product do not have any listed ETFs, but there are investment trusts available such as NB Global Floating Rate Income Fund (NBLS) which hedges USD exposure back into Sterling. As with investing in any investment trust, returns are subject to fluctuations in the share price premium or discount to net asset value.
Next in the capital structure is unsecured debt, which includes all types of corporate Bonds. Corporate bonds will be covered in a future article, as there is more to them than meets the eye, but are effectively unsecured loans made by investors in return for a fixed coupon, or interest rate. Because the debt is unsecured, the bondholder expects a greater rate of return on the investment than someone owning secured debt.
ETFs have really opened up this asset class, and there is a plethora of different corporate bond ETFs which investors can purchase. These range from short dated bonds, investment grade and high yield debt (historically known as ’junk bonds’), to bond ETFs that exclude certain sectors such as financial.
The corporate bond market is seen as a huge area of growth by ETF providers, as they provide liquid and diversified exposure to the asset class. Diversification removes much of the individual company risk that someone buying the debt of, let’s say, British American Tobacco (BAT) would face. For example, the iShares GBP Corporate Bond ETF (SLXX) has 340 holdings, with a 1.8% exposure to BAT.
Preference shares are a bond-equity hybrid, which give the holder a fixed dividend, which sit above ordinary shareholders in the capital structure. They can be cumulative, meaning that any missed payments must be paid before equity holders can receive anything, or non-cumulative meaning that missed payments will not be paid.
As with senior secured debt, the UK market is much less developed than the US market. However, as preference shares are listed securities, they can be bought on share dealing platforms such as IG’s. A better known example is the Lloyds Banking Group 9.25% perpetual, which currently trades at a premium to par and yields 6%.
Common stock, or equity, sits at the bottom of the capital structure and is the riskiest part of a company but offers an investor the potential of unlimited capital growth. To compensate an investor for the risks they take, equity ownership should outperform bonds over time, but there may be rather long periods where this is not the case.
What does this mean for your investments?
In risk-managed portfolios, such as IG Smart Portfolios, the least risky portfolios will have the lowest return expectation and a higher exposure to bonds, while the most risk-seeking portfolios will have a larger allocation to equities and should generate a higher total return in the long run.
Your portfolio manager is tasked with generating the best possible risk-adjusted returns, which may mean buying assets which seemingly have a low total return outlook (such as UK corporate bonds) in order to achieve diversification and low risk.