Corporate bonds

Ben Peters, February 2009

What are corporate bonds?

Corporate bonds are simply loans to companies. As with any other type of loan, the borrowing company pays interest on the amount borrowed at a rate determined when the debt is arranged. This rate is known as the coupon and determines the amount payable per £100 borrowed. The bond usually has a date set for repayment called the maturity, and is taken out in units of £100.

For example, if fictional retailer Benco wants to borrow some money, say £1million, they would create 10,000 bonds worth £100 each with a coupon of, say, £5. This means that the interest paid on the loan is 5% per year (the interest rate simply being the coupon divided by the bond price). If the maturity is 1^st March 2019, this is when they pay the £100 face value of the bond back.  As an investor you might purchase one or more of these bonds from Benco when they are created and receive the £5 coupon every year as income, until 2019 when you will get £100 back for each bond you own.

The £100 is known as the nominal or face value of the bond. However, you don’t necessarily need to buy the bond directly from Benco. You can buy them from other investors if they want to sell them on the secondary market (the direct purchase from the issuer being known as the primary market). Just like shares and other things bought and sold on an open market the price is not fixed, and so it is possible to buy £100 of face value for less than (at a discount to) or more than (at a premium to) the £100 nominal. And, as with other investments, this can create opportunities for finding bargains if bonds are selling at a low value.

There are two important points to note when paying an amount for a bond that is not the face value. The first is the interest rate you receive, known as the yield. Let’s say that you buy the Benco bond for £90, i.e. at a £10 discount to the face value. Benco still pays you £5 per year for the bond, and so the yield you receive is no longer 5%, but is 5.56% (£5 coupon divided by £90 purchase price). You get the same amount of income but have paid less money. The reverse is true if a bond is bought at a premium, and the yield will be less. This measure of yield is known as the running yield.

The second point is that when Benco repays the bond, it repays you £100, while you only paid £90. You therefore see an appreciation in your capital in 2019 of 11.1%. This appreciation is taken into account in the calculation of the redemption yield. In the example above where a bond is bought at a discount, the redemption yield is larger than the running yield, reflecting the capital gain on maturity.

Moves in the price of bonds in the secondary market make no difference to the cost of these bonds to Benco, who will continue to pay £5 per £100 borrowed. That said, if the prevailing yields are higher in the future then any new issuance of debt will have to come with a higher coupon to attract investors, otherwise they will just buy into the secondary market.

 

What factors affect the price of corporate bonds?

There are many factors that affect investors’ attitude to buying debt, all of which combine to give the final bond price. The impact of three factors, default risk, base rates and inflation, are described below. Of critical importance is what is happening in the market for government bonds. UK government bonds are called gilts.

Gilts are similar to corporate bonds, except that they are loans to the government rather than a company. You can buy them in exactly the same manner as corporate bonds, either direct from the government or in the secondary market. The key fact about gilts is that they are considered to be entirely free from risk of default, i.e. the government will always pay you your money back if you lend it to them. This is a reasonable assumption because, not only has the UK government got past form in always repaying debts, but it also has the power to print money to repay creditors if it doesn’t have sufficient funds (this may lead to other consequences such as high inflation, but the point in this context is that the loans get repaid).

 

Default risk

Companies, on the other hand, are generally not considered to be as reliable a debtor as the government. This means that the rate of interest paid by companies is usually above that paid by the government, to compensate lenders for the extra risk involved. The difference in interest rate is called the risk premium.

The risk premium demanded from investors is not constant. It changes with time depending on the outlook for the company. If some piece of news means that the company is at more of a risk of not paying back its debts, the risk premium that investors will want for lending the money will increase and the yield on the corporate bonds in question will rise, meaning a fall in the price of the bond. The opposite is true for an improvement in the credit position of the company. Changes in the outlook for companies also affect the rates that they pay in the primary market.

In the example of Benco above, the bonds issued had a maturity of ten years and a coupon of 5%. At the time of writing the yield on ten year gilts is around 4%. The risk premium you get for investing in Benco rather than the UK government is therefore 1% per year.

The risk of default by both companies and governments (not all government debt is as reliable as the UK’s, and even the UK has a tiny risk of defaulting) is monitored by independent companies, the ratings agencies. The agencies ascribe a quality rating to organizations and the debt that they issue. The ratings are formulated from a mixture of quantitative (mathematical) and more subjective methods, and are closely watched by buyers of bonds. Any downgrade in the quality as determined by the agencies is usually accompanied by a decline in bond prices, with a consequent increase in yield for the bond in question. The risk premium therefore increases.

 

Base rates

The interest paid on gilts is closely linked to the base rate set by the Bank of England. If base rates go down, the yield on Gilts goes down (or, equivalently, prices rise). But, all other things being equal, the relative risk of having the government owe you money (to all intents and purposes zero) and a company owe you money (more than zero) is the same. The yield on corporate bonds will therefore also go down, or equivalently prices rise, in order that the risk premium stays the same.

Another point to consider is that if base rates are low, investors will get a low rate of return on investing in gilts or keeping money in the bank, perhaps even negative once inflation has been taken into account. This will encourage people to look for better returns, possibly from corporate bonds and shares meaning that the prices of these assets will rise as people buy into the market. The converse could be true for high base rates- why take on the extra risk of lending to a company when you can get a perfectly good return by lending to the safest borrower of all?

 

Inflation

Inflation plays a vital role in determining bond prices. When inflation is high, this is bad news for bonds as the nominal value of the bond and the coupon paid remains constant in time. Their real value will therefore be eroded between now and when the cash is received. Investors will be less likely to invest in bonds and their prices will fall, raising yields. This is true for gilts and corporates alike.

The UK government (or, more precisely, the Bank of England) use base interest rates to try to control inflation. As discussed above, base rates directly influence corporate bond yields because of the risk premium being linked to gilts. To make things more complicated, it is possible that a company’s default risk is linked to inflation. If inflation is moderate then its earnings should rise as prices of its goods increase. However, if inflation is high then it may not be able to pass on rapidly rising costs to its customers and profit margins will be reduced.

 

Why invest in corporate bonds, and what are the downsides?

High quality corporate bonds offer a fixed rate of interest, with a set date on which you will receive your capital back and prices that are generally less volatile than investing in equities. These are clearly all attractive qualities for an investment. This is especially true for those that cannot, for whatever reason, tolerate the larger temporary fluctuations in share prices, for example those approaching retirement.

However, the returns have to be taken in the context of other investments that are available at the time funds are available. There is limited scope for capital growth with corporate bonds, unlike equities; even if you buy the bond at a discount the increase in capital is limited to the difference between the face value and the purchase price. So the lower volatility of bonds is countered by limited returns. As has been alluded to above, other fixed-interest investments such as gilts might offer acceptable returns with lower risk.

It is always vital to remember that any investment carries some risk. There is the possibility that a loss of capital could be incurred, either through price declines, defaults or erosion of the real value by inflation.

 

How do you invest in corporate bonds?

For the majority of people, investment in corporate bonds would be achieved by purchasing units in a fund specializing in investment in fixed interest securities. The manager will be an expert in the bond market, and typically hold 100-200 credits from a diverse range of issuers, reducing the risk of any one default affecting the overall investment return.

There are a great number of funds available, many of which focus on a particular type of bond or region (corporates, gilts, high quality, low quality, UK, global…..). The choice made depends on the circumstances of the individual investor and the prevailing economic conditions.

You can of course buy individual credits from issuing companies. This is fine if one has sufficient know-how and a large enough sum of money to invest, enabling the construction of a well-balanced portfolio. Such as method of investing is time-consuming, arguably more risky than using a dedicated manager, and dealing costs can prove prohibitively expensive for those that have more limited sums to invest.

 

In conclusion…

To summarize, corporate bonds are simply loans to companies. There are a number of factors affecting the yields paid by the bond, many of which are intrinsically linked to the prevailing economic situation. Corporate bonds offer attractive qualities generally as part of a more defensive portfolio, such as lower fluctuations in price than equities and reliable income. This may be of interest if you want a greater degree of certainty in the capital values of your investments. If the conditions are right, such as during times of low general market values, they may also provide superior income and/or returns to other available investments.

By using a knowledgeable fund manager, you can access investment in corporate bonds and make use of their qualities in a well-rounded portfolio.