Corporate bonds

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  • 16/09/2013
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Residents of the United States, please read this important information before proceeding

Please read this important information before proceeding.

Corporate bonds have become increasingly popular with retail investors in recent years, since they offer the possibility of a significantly higher income than cash deposits and UK government bonds. However, it is important to remember that with this increased income comes increased risk, with the highest-yielding bonds often being very risky indeed.

Corporate bonds are divided into two broad categories: “investment grade”, which are considered the safest, and “speculative grade”, “junk” or “high yield”, which are much more risky. Within this, bonds can have one of several different ratings, ranging from AAA, which means extremely strong, to D, which means the company has defaulted. The cut-off point between investment grade and non-investment grade is BBB-.

As with government bonds, the yields on corporate bonds have come down significantly in recent years. (This is because bond prices and yields move in opposite directions to each other and, as investors have flooded into bonds, so prices have gone up and yields have fallen.) At the same time, default rates among the companies issuing these bonds – even the riskiest grades – have remained low. However, investors should think carefully about whether poor-quality companies are likely to be able to continue servicing their debt burdens when interest rates finally begin to rise again.

Historically, bonds with ratings just below investment grade have delivered the best long-term average returns – while they had higher risks than safer investment grade bonds, their higher yields compensated for that. However, the higher yields available on even riskier bonds did not generate better returns still – these were eventually offset by higher defaults. As ever, past performance is no guarantee of future returns, and investors who are tempted by the relatively high yields still available on the riskiest bonds should tread cautiously.

While most individual investors will use funds to invest in bonds, direct investment in retail bonds quoted on the London Stock Exchange is becoming increasingly popular. These can be traded just like regular shares and have opened up a different way for individual investors to build diversified income portfolios by themselves.

It is vital to remember analysing bond investments means analysing both the strength of the company and the structure of the individual bond.

However, it is vital to remember that investing in bonds is different to investing in shares, and that analysing bond investments means analysing both the strength of the company and the structure of the individual bond. For example, even if two very similar companies issue bonds with similar interest rates and maturity dates (the time when the capital is repaid), one cannot assume those bonds have similar risks: one set of bonds might be secured against specific high-quality assets and be more likely to be repaid if the issuing company defaults, while another might be unsecured. So, before diving into retail bond investing, it is important to make yourself familiar with how the market works and how to analyse bonds, so that you can understand the trade-off between income and risk that each investment offers.

Investing ideas

The most popular corporate fixed-income funds in the UK are M&G’s Corporate Bond Fund and Strategic Corporate Bond Fund and Fidelity’s MoneyBuilder Income Fund. These funds have good track records but now manage several billions of pounds’ worth of assets, which might limit their flexibility in future.

You may therefore wish to consider a smaller player, such as the Henderson Sterling Bond fund which has been awarded the top five-crown rating by research company Financial Express.

Alternatively, if you are willing to take a higher risk with a specialist high-yield bond fund, one popular choice is the three-crown Kames High Yield Bond Fund, which currently yields 6.25 per cent – a figure that will vary and that may go up or down in future.

Investing directly in retail bonds is generally a higher-risk option than holding a bond fund because there is less diversification of risk. Each bond should only be a small part of a wider portfolio. Among recent issues, the Intermediate Capital Group 6.25% 2020 bond could be one interesting medium-risk choice. Both ICG’s name and its line of business – it provides financing for corporate and real estate deals – are less well known to individual investors than many companies in the retail bond market. Consequently, it has perhaps had to offer a slightly higher yield than other companies of comparable risk to attract attention.

The bond currently trades on a “yield to maturity” of 5.8 per cent – the annualised rate of return you would expect to make by holding the bond until it matures, including both the coupons you will receive and any gain or loss from the difference between the price at which you can currently buy the bond and the value at which the company will redeem it in 2020.

On the other hand, the London Stock Exchange’s own 4.75% 2021 bond has been very popular with investors, who have pushed up the price – it currently offers a yield to maturity of 4.2 per cent. However, this may still be reasonably attractive given that it is one of the lower-risk retail bonds yet listed.

Remember that the value of investments can do down as well as up and you may get back less than you invest.