Get back to basics on corporate bonds

Corporate bonds form the bedrock of many investment portfolios, and are frequently recommended by independent financial advisers. But, given that they are arguably more complicated than the average stockmarket fund, it can be tricky to grasp how they work and the role they should play in your overall investment strategy.

These products largely appeal to cautious investors who don’t want to commit too much money to the vagaries of the stockmarket but who need to generate income. This makes them particularly useful for those investors who are either in or approaching retirement.

"Generally, bonds offer a good income and a lower-risk profile than equities,"says Gavin Haynes, investment director at independent financial adviser Whitechurch Securities. "But they also form an important part of a balanced portfolio as a middle ground between cash and equities in terms of risk and return."

Put at its simplest, a corporate bond is a loan you make to a company to help it raise funds. In return, the issuer provides you with a steady stream of income (similar to the interest you would pay on a debt) and the promise to repay your capital at a set date in the future.

As corporate bonds are loans made to companies, they’re riskier than UK gilts - which are loans to the government as they are more unlikely to default. However, you do earn a higher rate of interest in return.

Corporate bonds are typically issued at £100 each and repay £100 when they mature, plus interest at a fixed rate each year until then. However, because bonds are traded on the world’s money markets their prices rise and fall according to demand, and this affects what you get back for your money.

The ups and downs

Like shares, bond prices go up and down - although not as dramatically - as prices are linked to long-term interest rates. "In an environment such as the current one, where interest rates are falling and there is economic uncertainty, corporate bonds will perform well," explains Meera Patel, senior fund analyst from IFA Hargreaves Lansdown. "However, if interest rates rise due to inflationary concerns, as may be the case going forward, these bonds may struggle to perform."

For example, if a bond has a fixed rate of 8% and interest rates start to fall, then an 8% return will start looking particularly attractive, so the price of the bond will start to rise - from £100 to perhaps £110. If, on the other hand, interest rates started to rise, the 8% return on the bond would start looking less competitive and so the bond price would drop below £100, and the investor’s return would slip.

Although bonds typically pay a fixed rate of interest, experts refer to the total amount you’ll earn on the back of your bond as the ‘yield’, because this takes into account the price of the bond.

"This is also known as the running yield," says Haynes. "However, a more relevant measure of the total return you will receive is the gross redemption yield, which is the annual expected return, including both the income expected and the capital growth - or loss - for the whole of the period up to the date of maturity of the bond."

The amount you earn will also depend on the strength of the company you invest in. Two agencies, Moody’s and Standard & Poor’s, specialise in grading the quality of corporate bonds. Ratings are based on ability to pay interest and the likelihood of the capital debt being repaid on maturity - the best rating is triple A (or AAA).

While blue-chip companies in the FTSE 100 index tend to be the safest and least likely to default on interest payments, and pay a steady but low interest rate, smaller companies engaged in riskier ventures are more likely to run into trouble, and so pay out greater interest to attract investors.

All bonds rated between AAA and BBB are called ‘investment grade’, and are at the lower-risk area of the bond market. Bonds rated BB or below are labelled ‘high yield’ or ‘junk bonds’, and these will pay higher yields but are higher-risk investments. A junk bond will offer attractive interest payments but the company behind it could well go bust - leaving the investor with nothing.

"For higher-quality investment grade, bond funds investors should expect running yields in the region of 5%, whereas for high-yield bond funds these are around 7% in the current climate," says Patel.

However, Haynes warns: "The credit crunch has demonstrated that a high rating doesn’t necessarily mean that a bond is secure. Also, a company may be downgraded in the future, and this can affect its desirability, so the price of the bond may fall."

There are other disadvantages to bear in mind before choosing to invest in corporate bonds. For starters, interest payouts will not grow over time, so purchasing power is eroded by inflation. Also, most bonds are redeemed at the same price as they were issued a few years earlier, so it’s hard to make significant capital gains.

No guarantees

Returns from corporate bonds are not necessarily guaranteed either. As corporate bonds are issued by a company, you take the risk that it will stay in business and continue to make money. So these bonds are only as safe as the company that issues them.

For example, the company may get into difficulties and fail to pay the capital at the due date. Such a risk will generally be reflected in the credit rating of the bond, so you should know roughly what you’re getting - although it can be tricky in today’s turmoil. Remember that the higher the yield the greater the risk of default.

"When assessing corporate bonds, consider the outlook for interest rates, how long it will be before the bond is redeemed and how financially secure the issuing company is," advises Haynes. "You then need to decide whether the risk you are taking will be rewarded by the potential return."

In the current financial climate, bond prices are being forced down as companies seek funding, prompting many experts to call a good buying opportunity as the credit crunch continues to bite.

There’s certainly plenty of bonds to pick from at bargain prices, as their price reflects not just the status of the issuing company, but also the attitudes of investors and conditions in the bond market. The recent market drop has seen banks seeking cash and selling whatever they can - and this again means more corporate bonds.

James Gledhill, head of fixed income investment at New Star, says that some bank debt is trading at 80p for every 100p issued, making now a great time to invest in corporate bonds. "Their price is highly volatile, but bond holders are better supported than equity holders as the financial structures of the banks remain in place, as we’ve seen with Northern Rock," he adds.

"Markets are undoubtedly in a choppy frame of mind, but the damage has taken place over the past year, as shown on the performance tables, and these bonds are looking very attractive now for medium-term investors."

High-yielding corporate bonds have been particularly hammered over the short term, but some advisers reckon the sector can only improve now. "The effects of the credit crunch really hit corporate bond markets last year and the first quarter of this year, resulting in significant capital losses," says Gavin Haynes. "For an area traditionally favoured by lower-risk investors this level of volatility is bound to cause concern."

"Compelling opportunity"

However, he adds that this now represents a compelling opportunity. "We believe that corporate bond returns have the potential to exceed those of cash over the next year, and the medium to long-term view for corporate bond funds is enticing."

Meera Patel agrees that the current slowdown seems a good time to jump in. "Interest rates have been falling and yields on many bonds have risen, and high-yield bonds in particular show potentially great performance to come," she says.

But not everyone is feeling so confident. Tony Ahearne, spokesperson for online investment rating service, says: "As more and more companies default on their loans, older, more experienced investors - who typically once piled in - are now giving corporate bonds a wide berth. Our advice is to channel any surplus funds into cash deposit accounts and enjoy the high rates of interest."

Of course, if you do wish to buy corporate bonds, you can do so through most stockbrokers. However, trying to cherry-pick a single corporate bond could lead you into a minefield - for the average investor it’s much more sensible to opt for a corporate bond fund. This will offer you access to a far wider range of bonds, and the fund manager will be able to adjust the fund’s holdings according to different market conditions.

"I believe that it makes sense to have a well-diversified portfolio investing in bonds both in the UK and overseas," says Haynes. "While funds investing in high-quality UK blue-chip corporate bonds make a good core to a portfolio, it’s important to remember that the UK makes up only around 5% of fixed interest markets."

However, just as with equities, the further afield you go, the higher the risk - so while there are some very attractive overseas funds, these come with a stronger health warning, says Philippa Gee, investments director at IFA Torquil Clark.

Gee adds: "Corporate bonds may not be the next hot investment - and the chances are they never will be - but they provide a solid alternative that over the long term will help the balance a portfolio."

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