What is a corporate bond?
A debt investment, a corporate bond is a loan from an investor to a company. This loan is then used by a company to raise money to pay bills or make new investments. Bonds are one of the most common financial instruments and are popular with investors wanting regular income.
Here, we explain how corporate bonds work and outline how you could invest in the asset class.
Why do companies issue corporate bonds?
Corporate bonds are an important tool in a company’s arsenal when it comes to raising capital. Whether the organisation wants to raise money to finance its expansion, finance an expensive project, or fund a merger or acquisition, issuing bonds can be an effective way to raise funds quickly, while being able to set very defined terms on the length of the bond’s term and the interest they will pay.
If there is a company you want to invest in, there are two main ways you can do so: investing in its stocks and shares (equity) or buying some of its corporate debt. Corporate debt is traditionally seen as a ‘safer’ investment than stock because bond holders receive their initial investment back once the bond matures, in addition to interest earned throughout.
Equity is regarded as riskier than corporate debt, although it has the potential to generate higher returns. Whilst corporate debt will provide you with a stable income, you have to accept a lower return.
Whilst bonds are great for providing you with regular income, your scope for return is limited and may not be able to keep up with inflation.
How corporate bonds work
To understand the characteristics and return of a bond investment, let’s look at a simple example.
Say you want to buy a corporate bond for £100 with a maturity of 10 years, paying a 2% regular coupon. This is what your cash flows will look like:
- You pay the corporate £100 for the bond – this is its face value
- Each year you will get £2 in interest for holding the bond
- After 10 years, you will get your principal £100 back
At maturity you will have £120 from the bond; the £100 you originally lent and £20 profit from the interest payments.
You’ll hear yield mentioned a lot in relation to bonds; this is just another way of saying the income return and is usually expressed as a percentage of the price. Yields have an inverse relationship with the price of a bond. As bond prices fall, yields will rise, and vice versa.
When investors look for riskier investments like equities, yields traditionally rise. Yields could fall when sentiment swings and there’s demand for safer investments. This could be the result of high unemployment figures or weak economic growth.
How do corporate bonds vary?
The issuer of the bond sets the length of its term. A bond’s term is the length of time before the issuer has to repay the initial investment back once the bond matures. Corporate bonds can be classified as short-term (usually 3 years), medium-term (5-10 years) and long-term (any bond with a length over 10 years).
The par value of a corporate bond is simply the face value of a bond. Par value is important for bond investors because it determines the maturity value and the value of coupon payments. However, as corporate bonds can be traded, their value can rise and fall. The market value of corporate bonds is largely affected by interest rates and inflation.
Their value is quantified in relation to their ‘par’ or ‘nominal’ value of 100. If a bond is valued at 95 relative to its par, this means it is worth 95% of what it was issued for. Conversely, corporate bonds can increase in value; a bond valued at 115 relative to its par is worth 15% more than its value at issue.
There are a number of different bond yields to calculate, including the nominal yield and current yield.
Nominal yield calculates the coupon rate of the bond divided by its face value, although it doesn’t always represent the overall value.
The current yield divides the annual cash inflows by the bond’s face value to reflect the return an investor can expect over one year.
The yield to maturity is calculated to measure the total return on a bond when it is bought, assuming it is held to maturity. It’s a very complex calculation that can help investors compare bond value.
While yield rates on corporate bonds do fluctuate, they are generally more lucrative than government-issued bonds such as gilts. However, corporate bonds are viewed as riskier.
All bonds come with a certain level of risk. The risk is the likelihood that the issuer will default on their repayments. The higher the risk, the higher the yield investors will demand to compensate for taking on this risk.
To help investors weigh up risk, companies are rated by credit ratings agencies who judge their risk of default. For instance, an AAA rated bond is thought to be extremely safe, with the company the least likely to default on their repayments – although this is still possible.
However, the ratings provided by the large agencies are not always accurate. Analysts believe reckless and inaccurate ratings of mortgage-related debt by the ‘Big Three’ ratings agencies in the United States directly contributed to the 2008 financial crisis.
Investing in corporate bonds
An investor has two options when in possession of a corporate bond. They can wait until the end of its term for the bond to mature, or they can look to sell the bond early. Waiting until the bond’s maturity will ensure full repayment of the value of the bond – providing the company doesn’t default on this payment. Selling the bond on the open market may allow an investor to make a profit on it.
Corporate bond traders look to profit from the fluctuation in the value of bonds – buying them when they are priced below their par value if they believe they will be able to make a profit in the future.
Trading corporate bonds relies on strong knowledge of the market, keeping up to date on inflation forecasts and good judgement of risk.
Finding the right balance between risk and return can be complex, and keeping on top of the financial chatter to predict any movement in interest rates can be time consuming.
As an asset class, bonds are the basic building blocks to any investment portfolio. If used correctly, can help an investor achieve their financial goals. But it can be tough integrating bonds into a diversified portfolio, ensuring they complement the dynamics of your other investments.
Exchange traded funds are popular with investors wanting low-cost, flexible and diversified fixed income exposure in their portfolio.