If you invest in a corporate bond you’re effectively giving a loan to a company. The idea is you get interest and, at the end of the term, the original amount you lent is repaid. How do they work?
Corporate bonds; the basics
A bond is an IOU from the issuer and a corporate bond is an IOU from a company.
- 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, at a price that could be higher or lower than the par value.
- 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.
Checking the risk of your bond funds
If you have money invested in a bond fund, and you don’t know how much risk you’re taking or what types of bonds your money is invested in, there are steps you can take:
1. 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.
2. 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. It’s important to think about why you invested and how much of your portfolio is in corporate bonds. A review with a professional independent financial adviser will show you whether or not you need to take action.
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