The Ins And Outs Of Investing In Corporate Bonds

11 mins

The Ins And Outs Of Investing In Corporate Bonds

The basics of bonds

Though not quite as sexy as the super spy, James’ older corporate brother is a favorite for those a little less keen on risk. Corporate bonds are a great way to diversify your investment portfolio, thanks to their (normally) negative correlation with stocks – but bonds can be confusing. We’ll cut through the jargon in this pack – you’ll have a license to kill in no time.

What are bonds? Bonds are a form of debt: money owed to someone. They are issued by governments (check out our Pack on Government Bonds for more on that) or companies, and when you buy one, you are essentially loaning money to that institution.

How do they work? A bond has a maturity date and a “coupon": you might buy a 10-year bond with a 5% coupon for $100. That means that you’re giving the company $100 for ten years. In exchange, the company will pay you 5% interest ($5) each year until maturation, when it’ll give you back your original $100 too.

What’s in it for the companies? Companies issue bonds to raise money for new projects (or to keep existing, loss-making projects going). There are other ways for companies to get this cash, but none are ideal: issuing new stock involves the company’s owners giving up some of their ownership stake; and getting a bank loan for huge amounts of capital isn’t always easy (and if it is, it might be costly). Bond issuance is a way for companies to borrow large sums reasonably easily and cheaply. The scale can be massive: Saudi Aramco made a $12 billion debut international bond sale in April 2019 to help fund its acquisition of a majority stake in local petrochemicals giant Sabic.

And for investors? Bonds are generally a lower risk investment than stocks. Fixed income and return of your capital at the end of the bond’s term mean bonds can offer stability you can’t get from shares. But the company could go bankrupt or default on some or all of its obligations, meaning you might not be repaid. Though even in those circumstances, bondholders get first dibs on any cash from a sale of the company – debt backed by assets gets repaid first, then “unsecured” debt. Shareholders split whatever value is left but in the case of bankruptcy this is almost always zilch.

You’re not stuck with a bond until maturity. As with most financial products, you can trade them. That’s where the fun really starts. So read on...

How to trade bonds

How does trading bonds work? Like stocks, corporate bonds can be bought and sold, so you can buy in late or get out before the bond hits maturity. There’s a lively secondary market to trade bonds, and there’s money to be made doing it.

Because the price of a bond can change, the coupon rate stops being a useful measurement of its value. Instead, you’ll see the yield quoted, which is the annual coupon payment divided by the market value of the bond expressed as a percentage. You might also see YTM, or “yield to maturity” quoted: that measures what the estimated return of the bond is if you hold onto it until maturity.

The coupon payments of a bond are set in stone when the bond is issued, which means that yield moves inversely to price. For example: a $100 bond pays $5 a year, so its yield is 5%. If the price of the bond goes up to $110, its yield decreases to 4.5% (5 ÷ 110). On the other hand, if the price drops to $90, the yield goes up to 5.6% – the coupon payment is now a greater proportion of the bond’s value.

What affects bond prices? Like everything, prices are set by good old supply and demand. More specifically, corporate bonds will move when other investments – like (generally safer) government bonds – start to offer a better return. If the US central bank decides to bump the general interest rate up to 2%, all bonds paying less than that are suddenly a whole lot less valuable – so their prices will fall, at least until the yield rises enough to outstrip the standard 2%. Prices also fall when inflation increases because future payments become less valuable, and when perceived risk of defaulting increases – but more on that in the next session.

Prices typically rise for bonds close to their maturity date because there’s more certainty that the face value will be repaid. They also tend to increase when the stock market is experiencing turbulence, as investors look for the stability and safety offered by bonds. However, higher-risk bonds might not see the same inflow of funds during turbulent times.

As for risk, there’s a whole industry built around calculating bond’s creditworthiness. Don’t be Moody: let’s take a look at rating agencies.

The risks of bonds

What are the risks of buying bonds? There are a few things to think about. Some bonds can be “called” early, meaning that the issuer can repurchase the bonds and there’s nothing you can do about it. The issuer might do this when interest rates have fallen because it can issue new bonds at a lower (read: cheaper) rate. As an investor, that’s bad news because it means you won’t get the future coupon payments, reducing the overall value of the bond.

Interest rates going up poses a less obvious risk but might cost you nonetheless. You might be stuck holding a bond that pays a 2% coupon when you could be getting 3-4% returns elsewhere. If this happens, the price of the bond is likely to fall and the yield rise – meaning you’ll make a loss if you sell.

The scariest risk of them all is your bond defaulting. If a company entirely runs out of money and declares bankruptcy, it might not be able to pay back its existing debts – so it will default on the bonds, and you’ll be left out of pocket. Or, even if a company doesn’t go entirely broke, it might be forced to skip a coupon payment or two to preserve cash.

Sounds scary. How do I protect myself? Fortunately, there are organizations called credit-rating agencies – the most well-known are Standard & Poor’s, Moody’s, and Fitch – which try to assess the likelihood of a company defaulting on its bonds. They assign a score to the company’s bonds, with AAA being the top rating, AA the next best, and so on. (There are slight variations in the way each agency writes its scores, annoyingly).

The scales go all the way down to C, and only about half of the ratings count as “investment grade” bonds. Below the cut-off point, you’re dealing with “non-investment grade” or “junk” bonds: they might pay a really high rate, but they’re much more risky.

The agencies are pretty thorough and look at a bunch of factors when deciding how creditworthy a company is: including financial data, strategy, and the general economic and competitive environment in which the company operates.

This isn’t just a one-time process either: ratings are continually adjusted as those factors change and a company can be upgraded or downgraded. If there’s a downgrade, bond prices will fall because investors demand a greater yield from riskier investments. Unfortunately for the affected companies, if a downgrade takes it into non-investment grade territory, funds that hold their bonds may be forced to sell as some funds have restrictions on what ratings they’re allowed to hold.

Don’t completely rely on rating agencies though. They’re often a lagging indicator, meaning that the price of a bond may have slipped a lot before the agencies catch up and change the rating. During the financial crisis of 2008, many of the debt securities backed by US mortgages that turned out to be nearly worthless had been given the top, AAA rating by agencies.

We know we bang on about this, but it’s always worth doing your own analysis of a company and its strategy before investing – if something seems really risky, you might want to avoid it.

Non-tradable bonds

My local bank offers two-year bonds in their savings account. Can I sell those if I want to get out sooner? It’s unlikely. So far in this pack, we’ve talked about bonds that you can trade, but it’s a widely used term for a bunch of financial products that you can’t sell on the secondary market.

They operate on the same general principle as the other bonds – i.e. you’re lending cash to a company – but because you can’t trade them they’re not quite as flexible. However, the aforementioned loss of flexibility can come with less risk. For example, bonds like the ones your bank offers may be financially secured by your government if the bank defaults (but check before you buy!).

In the UK, for example, “mini-bonds” are a specific non-tradable category of bonds which often come with a three- to five-year term. Large companies have used these to raise money (including retailers like John Lewis and Tesco) and they sometimes even incorporate quirky twists like interest being paid in chocolate or retail vouchers. They’re popular with firms because of the laxer regulatory requirements, but that means there’s also increased risk. Firms have been known to go bust with investors losing all their capital.

If I buy a bond on the secondary market, will I definitely be able to sell it? Not necessarily! The market for corporate bonds is often quite illiquid, meaning there aren’t always many buyers and sellers. You might not be able to sell a bond straight away, and you might have to settle for a price lower than you were hoping for – a tradeoff you might be okay with if you’re desperate to rid yourself of the bond.

As you can see, things can get complicated fairly quickly. If you want a more hands-off approach to bond investing, a fund could be the way to go. Next, we’ll explore their pros and cons.

Bond funds

How do bond funds work? Like stock funds, a bond fund is a bundle of bonds. Your cash is pooled with your fellow investors’ money and used to buy a bunch of different bonds, aiming for a certain return and risk level.

There are two main kinds of bond funds: actively managed funds, and passive “index-tracking” funds. The latter is the simplest and cheapest – they’ll track the performance of the bond market, with you able to choose whether you want to focus on global bonds, a specific country, or a particular risk level.

As the name implies, an actively managed fund has a person running it. This fund manager will decide what bonds to buy in an attempt to outdo the wider market. Full disclosure: it’s pretty hard for them to do that, but there’ll always be the occasional manager who can beat the market. Because there’s no such thing as a free lunch, you’ll be paying for the privilege – actively managed funds tend to have fees up to five times higher than passive funds.

Why do this instead of directly investing in bonds? Investing in a bond fund is a much easier way to build a diverse bond portfolio than doing it all yourself because you’re outsourcing the research work to someone else. Having some help can be a significant advantage, especially if you’re looking to invest in markets you’re not super clued up on.

The big disadvantage of a bond fund, other than the fees, is that you don’t actually own the bonds. When you directly own a bond, you have a certain level of security. Unless a bond defaults, you will be paid a predetermined amount on the bond’s maturity date. However, because the fund is continuously trading bonds rather than holding onto them, you don’t have that security of an eventual repayment. This arguably puts you more at risk of a capital loss.

When you choose a bond fund, decide your risk tolerance, and what area to invest in – whether safer US bonds or wild high-yield emerging market bonds. You can find a few funds which invest in those areas online. To decide between these, have a look at the fees, the strategy, and track record of both the fund and the fund managers. Hopefully, you’ll find something that chimes with what you’re looking for – then you’re good to go.

Bonds don’t have to be complicated. With your newfound knowledge, a whole new asset category has opened up to you, and as we’ve explored, they can be a great addition to your portfolio. Good luck with your new investments: yield for no one.

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