How do corporate bonds measure up?
It has been difficult to know where to invest since the financial crisis began. Equities around the world have been in freefall, property prices have slumped and plunging interest rates have meant lacklustre returns for savers.
However, the gloomy economic backdrop is good news for one particular asset class: corporate bonds. While stockmarkets yo-yoed, these fixed income products have grown in popularity among people wanting a safer haven for their cash.
While they can never lay claim to being the sexiest type of investment, nor the ones most likely to deliver bumper returns in good times, corporate bonds certainly tick all the boxes when it comes to providing a regular income and long-term capital growth, and form an important part of a balanced portfolio as a middle ground between cash and equities in terms of risk and returns.
According to Darren Ruane, a bond strategist at Rensburg Sheppards Investment Management, interest in bonds has increased sharply since the Bank of England started dramatically cutting rates in October 2007.
“Investors are suddenly receiving a very low return on cash in bank accounts and understandably want a higher yield,” he says. “As they don’t have any faith in equities they have started looking for other sources of income.”
So what exactly are corporate bonds and how do they work?
In simple terms, a corporate bond is an IOU issued by a public company. Buying one effectively means you are lending the firm money in exchange for a fixed rate of interest over a pre-determined period, as well as your original investment returned on a specified future date. As corporate bonds are loans made to companies, they’re riskier than UK gilts that are loans to the government, which are less likely to default.
Every bond has a nominal value – usually £100 – which is the amount that will be paid out to holders when it reaches the end of its life. Although these life spans vary, they are generally less than 10 years.
The fixed rate of interest you will be paid is also made clear at the outset. For example, a bond offering 4.5% would be particularly attractive at the moment as it’s much higher than the base rate set by the Bank of England.
Therefore, if you buy a 10-year bond with a nominal value of £100, which is paying 4.5% interest, you will receive £4.50-a-year on your investment, plus your original outlay paid back when it matures.
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’ as this takes into account the price of the bond.
The price paid for bonds will depend on various factors, including how well a company is perceived to be doing, as well as rising interest rates and inflation.
Inflation is the ultimate villain as far as bond investing is concerned, as the Bank of England is likely to combat rising prices by increasing interest rates. When inflation rises a lot before the bond
matures then the fixed income payments – as well as your principal investment – will be worth a lot less.
For example, if it was offering a return of 4.5% and interest rates were well below that level, it would be attractive to potential investors and the market price could increase by, say, 10% to £110.
However, if interest rates were on the up then the fixed rate wouldn’t look so appealing and the price could fall to under £100.
According to Darius McDermott, managing director of Chelsea Financial Services, the principle reasons for holding bonds are to reduce the overall risk of a portfolio and to produce a decent level of income. That’s why the percentage of your portfolio that’s held in bonds should increase the closer you get to retirement to ensure you won’t make a massive stockmarket loss by the time you need to realise your investment.
What about returns?
While corporate bonds could be an ideal investment for those near retirement or those who specifically want a low-risk investment product, investors looking for greater returns have typically opted for equities instead. However, given current market conditions, could this asset class offer opportunities for less risk-averse investors too?
Geoff Penrice, a financial adviser at Bates Investment Services, believes that the current economic climate suits corporate bonds very well. The only question vexing investors, he believes, is how long the good times will last.
"Corporate bonds tend to perform well when inflation is low and when interest rates are falling, both of which are happening now,” he says. “As long as we don’t have Armageddon, I think now is a
good time to be investing in corporate bonds and we should have good returns over the next few years.”
Adam Cordery, a bond fund manager at Schroders, concurs. “We agree that a nasty recession is likely, we think in many cases we are being overcompensated to hold credit, which is why it is a great time to enter the asset class.”
However, the yields being offered on corporate bonds won’t last indefinitely, he warns, and are likely to be significantly lower in two years’ time on the assumption we are half way through the global recession.
There’s also no guarantee that the investment will be repaid in full as the company issuing the bond may end up going bust or encounter problems along the way in meeting its interest payments.
To help you form a judgment about a company’s prospects, specialist credit agencies, such as Moody’s and Standard & Poor’s, look at each one and apply a rating based on their assessment of a firm’s ability to pay back the sum borrowed.
The most trusted will be given a triple A (written as AAA) ranking, and then it goes down on a sliding scale through AA, A and BBB. Anything rated BBB or above will be classed as investment grade; those with lower ratings are known as high yield or junk bonds.
Both the amount of risk you are taking and the level of your potential return will increase as you move down the ratings scale. Therefore, while you can certainly earn more from a BBB credit than one that is AAA-rated, it is also more likely to fail.
Of course, these issues are only relevant to people holding individual bonds; they don’t apply to bond funds, such as unit trusts, investment trusts or Oeics, as these invest in a range of corporate and government bonds.
Investing in a corporate bond fund is the simplest way of getting exposure to the asset class as a specialist manager will decide whether to invest in medium-risk or high-risk bonds, or a mixture of the two, depending on the fund’s overall objective.
Corporate bond funds are classified in a variety of sectors by the Investment Management Association (IMA), depending on their construction and the overall objectives of the individual portfolios. These include the IMA Corporate Bond sector, the IMA Strategic Bond sector and the IMA High Yield sector, as well as IMA Global Bonds and even IMA UK Equity & Bond Income, which has a mixture of bonds and equities.
Darius McDermott advises that you should pay attention to the definitions of the sectors and stick to household-name funds and managers as they will have a better chance of enjoying long-term success.
“Unless you have the time and expertise to research them yourself, you should invest in a bond fund manager,” he says. “We particularly like the Henderson Strategic Bond and the M&G Optimal Income as they have good track records and fund managers who have proved themselves during various credit cycles.”
So which areas of the market do corporate bond managers like at the moment? The majority appear to be favouring the investment grade arena, as these bonds are still offering decent yields but are not as risky as high yield.
Chris Bowie, head of credit at Ignis Asset Management, points out that investors can enjoy double-digit yields via a string of household names, such as Barclays, BT or Imperial Tobacco.
“Investment-grade credit has never been better value,” he says. “For perspective, a typical bank account would take seven years to achieve a return equal to the annual yield you can buy on a Sainsbury’s secured bond.”
Richard Woolnough, a bond fund manager at M&G, has been selling out of safer government bonds and investing in corporate names over recent months because they have fallen to such attractively low levels.
“You’re getting paid excessively for taking risk so that’s why we have been buying the likes of BSkyB and Vodafone,” he explains. “We see both companies as reasonably recession-resistant in their own areas.”
But not everyone is feeling so confident. Charlie Morris, manager of the HSBC Absolute Returns Service at HSBC Global Asset Management, agrees bonds were once the best option, but questions whether this remains the case.
“We don’t believe you should hold credit over the cycle,” he says. “The only time you should buy credit is in the early stages of a recovery when you’re getting paid for taking the risk. The rest of the time it should be ignored.”
The big question is whether the monetary and fiscal stimulus packages announced by central banks around the world are enough to limit the damage to companies.
Ironically, the fiscal stimulus could actually lead to inflationary problems over the coming months – and this would not be good news for corporate bonds.
Either way, it is certainly too much of a sweeping statement to say that all bonds will be good value by the time 2010 rolls around, acknowledges Tony Yousefian, chief investment officer for OPM Fund Management.
“Certain sectors of the bond market will remain extremely unattractive – particularly high yield,” he explains. “My expectation is that the number of defaults will increase.”
Stewart Cowley, the former manager of the Newton International Bond fund, believes the decision whether to put money into bonds depends on if you believe a particular company will still be around on the maturity date.
“If investors expect it to be there – and to be able to pay its interest payments in the meantime – then they should buy,” he says. “It sounds simplistic but it has come down to deciding who will be the survivors. The good companies that will be around in the future are the ones that are outstanding investment opportunities.”
Equity Income funds: another alternative
Equity Income funds could be an alternative for people who don’t want to invest in corporate bonds, according to Darius McDermott, managing director of Chelsea Financial Services. The aim of these funds is to provide an income for clients by investing in companies that are paying decent dividends – and will continue to do so irrespective of what happens to markets over the coming year.
“Equities have been extremely volatile but are now cheap and offering a decent level of income,” he says. “For the risk taken you can get a substantial return.”
McDermott recommends sticking to tried-and-tested funds. “We like Invesco Perpetual High Income, Artemis Income and Standard Life Equity High Income,” he says. “They are all run by proven, experienced managers who have consistent track records.”
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
Open-ended investment companies are hybrid investment funds that have some of the features of an investment trust and some of a unit trust. Like an investment trust, an Oeic issues shares but, unlike an investment trust which has a fixed number of shares in issue, like a unit trust, the fund manager of an Oeic can create and redeem (buy back and cancel) shares subject to demand, so new shares are created for investors who want to buy and the Oeic buys back shares from investors who want to sell. Also, Oeic pricing is easier to understand than unit trusts as Oeics only have one price to buy or sell (unit trusts have one price to buy the unit and another lower price when selling it back to the fund).
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
An individual employed by an institution to manage an investment fund (unit trust, investment trust, pension fund or hedge fund) to meet pre-determined objectives (usually to generate capital growth or maximise income) in prescribed geographic areas or investment sectors (such as UK smaller companies, technology or commodities). The manager also carries the responsibility for general fund supervision, as well as monitoring the daily trading activity and also developing investment strategies to manage the risk profile of the fund.
Corporate bonds are one of the main ways companies can raise money (the other is by issuing shares) by borrowing from the markets at a fixed rate of interest (the reason why they are also known as “fixed-interest securities”), which is called the “coupon”, paid twice yearly. But the nominal value of the bond – usually £100 – can fluctuate depending on the fortunes of the company and also the economy. However it will repay the original amount on maturity.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.