Corporate bonds explained: how do corporate bonds work and who should invest?


A few days ago a SavvyWoman user emailed to ask what corporate bonds are and how you invest in them, so I thought I’d explain the basics. If you invest in a corporate bond you’re effectively giving a loan to a company as corporate bonds are IOUs and they’re often recommended as a way of spreading your risk. The problem, according to some financial advisers, is that the next couple of years are likely to be a difficult time for corporate bond funds (funds that invest in corporate bonds). So, what should you do?

Corporate bonds; the basics
A bond is an IOU from the issuer and a corporate bond is an IOU from a company (you can also invest in government bonds and even local authority bonds).

– Corporate bonds have different risk levels: Corporate bonds are graded by credit ratings agencies (such as Moodys and Standard and Poor’s). The least risky corporate bonds are rated as AAA and the riskier are known as high yield — with junk bonds at the riskiest end of the spectrum.

SAVVY TIP: Although companies are graded on their perceived level of risk the ratings agencies can get it wrong and a company’s fortunes can change pretty quickly. Remember Lehman Brothers? Or Marconi? Even giant and well known companies can default on their loans.

– The interest you earn depends on the rating of the bond (among other things). In return for loaning a company your money you receive interest. The level of interest you receive depends — in part – on how risky the particular company’s corporate bond is.

SAVVY TIP: The higher the return that’s offered the greater the risk that you may not get back the original amount you invested (which is called the ‘principal’ or ‘principal sum’).

– Corporate bonds generally have a nominal or ‘par’ value of £100. However, that doesn’t mean they will always be worth £100. Corporate bonds can be traded at a premium (‘above par’, which means you’ll pay more than £100) or at as discount (‘below par’, which means you’ll pay less than £100).

SAVVY TIP: If you hold the bonds until maturity you should get back the full value. However, if you invest in corporate bonds via a bond fund, the fund manager will buy and sell holdings in bonds at different times, which could be higher or lower.

– Corporate bonds are affected by several factors. The main ones are interest rates, inflation and the outlook for the particular company. If interest rates in general rise, the value of the corporate bond will fall. That’s because the interest rate (or yield) that the bond is paying will look less attractive because investors can get a better return by putting their money in a savings account (in theory at least).

SAVVY TIP: The price of corporate bonds is also affected by inflation. Higher inflation pushes down the price of bonds issued when inflation was lower. But if inflation was due to fall then older bonds paying a higher interest rate would look more attractive so their price would rise.

A way of spreading risk…
Traditionally, investors have been advised to split their money between shares, cash (savings accounts etc) and bonds as a minimum to spread their risk, with corporate bonds being riskier than cash accounts but not as risky as shares. But that’s not necessarily the case now.

– Philippa Gee of Philippa Gee Wealth Management says that the current environment, with higher inflation and the prospect of rising interest rates that’s not true. “Corporate bonds may be riskier than shares. The moment interest rates rise there will be a wall of money bailing out of corporate bonds. That won’t just affect the income but it could reduce the value of corporate bonds significantly.”

What should you do?
The prospect of higher interest rates doesn’t mean you should sell your corporate bond fund investments (and you should definitely take independent financial advice if you’re thinking of changing your investments). However, there are steps you can take:

– Find out where your money is. If you have money invested in corporate bond funds, dig out the paperwork and go online to the provider’s website and log onto the latest fund factsheet. This will tell you what type of bond fund you’re invested in, the top ten companies it holds bonds in, the performance and the fund manager’s outlook.

SAVVY TIP: If you can’t find the fund factsheet online you can always ring the provider and ask for a copy of it. It’s worth knowing that the performance figures will often be relative to other funds in the same sector, so your fund may be better than average but if the entire sector has taken a hit you could still lose out.

– Review your investments. This is particularly important if you have a significant chunk of your investment money in corporate bond funds and you invested in the last couple of years mainly for capital growth (i.e. a rise in value), rather than the income payments says Karen Ritchie an IFA with FPW. “Think about why you invested and how much of your portfolio is in corporate bonds.” A review will show you whether or not you need to take action.

Useful links:
The independent money information website Money Advice Service has a guide to bonds, which is user friendly.

Related articles:

A beginner’s guide to gilts

Do you need to review your financial plans?

How to find an independent financial adviser you can trust

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