FOOL'S EYE VIEW
Investing In Corporate Bonds

By James Carlisle
April 29, 2002

It's often said, on this website as much as anywhere else, that if you're investing in shares, it should be with money you don't need to touch for at least five years. In fact, the longer you go, the safer they become. Shares have beaten cash in 78% of all five-year periods since 1869. For ten-year periods, the figure increases to 93%, for 20-year periods it's 95% and for 30-year periods it's, well, every single time (though that doesn't mean that you can never lose over 30 years).

There's more detail on these figures in this thread of posts on the Investing Strategies discussion board. Anyway, it isn't just a case of saying "my time horizon is more than 5 years, so shares it is". It's a balance between time horizons and how much risk you can cope with.

Shares will generally provide the answer for longer time periods and where some risk is acceptable and, the more you satisfy one of these, the easier you can afford to go on the other. Cash and gilts, which are IOUs issued by the Government, are for shorter time periods and where you don't want any risk and, the more you satisfy one of these, the less tolerant you can be on the other. Somewhere in the middle of all this come "corporate bonds".

How They Work

Corporate bonds are IOUs issued by companies and, though they're more risky, they work similarly to gilts (these are described in more detail in Grappling with Gilts, parts one and two and in this Bank of England leaflet). Generally, corporate bonds come in lots of "£1,000 nominal" and they have a "coupon" and a "maturity date".

So, if you bought £1,000 nominal of "Tesco 7.5% 2007", then Tesco would pay you the £75 per year (that is 7.5% of £1,000) each year until 2003, when you'd get the £75 interest, plus your £1,000 back (on 30th July to be precise). The £75 payments are called the coupon.

You might have noticed, though, that 7.5% is a lot higher than base interest rates (currently 4%). That makes the bond more valuable than the face value of £1,000. Only a little bit more valuable, because there are only six more coupon payments to come, but more valuable all the same. In fact, the market values these Tesco bonds at 107.89% of their nominal value, or £1,078.90 for each £1,000 nominal.

The fact that what you get back at the end is less than you pay means that annual return that you get on the bond is less than the coupon. This annual return is called the "yield to maturity" or the "yield to redemption", or the "redemption yield". It's quite tricky to calculate ( this article explains how it's done), but it's the most important number since it tells you what your total annual return will be if you hold the bonds until they mature (assuming that the company doesn't go bust). For these Tesco bonds, the redemption yield is 5.68%. That compares to the redemption yield on a gilt maturing at around the same time of about 5.17%.

So the question is, are you prepared to take on the risk of Tesco going bust in the next 2 years, for the sake of an extra 0.5% on your annual return? It's tempting, but then if you absolutely definitely must have the money in two years' time...

Buying Corporate Bonds

You buy corporate bonds from stockbrokers but not all of them, particularly the discount brokers, will provide the service. So it's a question of finding a broker who'll do it for you. Information on corporate bonds is also very hard to come by. There is some data in the International Capital Markets section of the Financial Times, but while it's good for gilts, the data for corporate bonds is very limited. Probably the best bet is to contact your broker. If they deal in corporate bonds, they should be able to give you some information.

Specify to the broker a date of maturity (coinciding with your investing period) and describe the risk you're prepared to accept by specifying how much more of yield you want than you'd get on a gilt. If you ask for a premium of less than 1%, then you should get a list of pretty solid companies. If you ask for a premium of 5% or more, then you'll get a pile of junk and you might as well stick to shares.

Be careful to check for any funny terms and conditions on the bonds. Some are convertible into shares, some are "callable" and some are all sorts of other things. With companies that have lots of different bonds, you might find that some rank higher than others in an insolvency. The bad news is that these things will affect the price and redemption yield of your bond. The good news is that the market is tends to be reasonably efficient and you'll generally get what you pay for, but you should try to keep things simple and make sure you understand what you're getting.

The other major problem with buying corporate bonds directly is that it's hard, expensive (or both) to get a wide enough spread. Just like shares, you wouldn't want to trust your money to just one company because, no matter how safe you think it is, it could go bust. So, you'll need bonds in perhaps 5 to 10 different companies. That means buying £5,000 to £10,000 'nominal' of corporate bond and each trade will have its own cost.

Corporate Bond Funds

A possible alternative to these difficulties is to invest via a corporate bond fund. As the name suggests, these are managed investment funds, mostly unit trusts, that specialise in corporate bonds. Although they sound as though they save a lot of trouble, there are some major problems.

First of all, you don't know what you're getting. If you buy the bond yourself, then you can pick a maturity date to coincide with your intended holding period. If you buy a fund, then you'll get a whole range of different maturities. This means that the value of your investment will vary with interest rates and it therefore adds to risk. Since you were using the corporate bonds to reduce risk, it's somewhat counter-productive.

Secondly, keep it very well in mind that there's no such thing as a free lunch. Bond funds will often advertise themselves as having yields of 8% or more. If they do, then you know they're investing in some risky stuff. Beware!

Finally, the fund charges can put a big hole in your returns. For example, if you bought a fund full of those Tesco bonds we looked at earlier, then the extra 0.5% yield you're getting over a comparable gilt would be more than wiped out by the 1-1.25% charges that are typical on a bond fund.

All in all, it's hard to make a good argument for corporate bond funds. If you're investing for a long time and can tolerate some risk, then some form of share-based investment is probably best. If you're investing for a short time, and/or can't tolerate risk, then cash or gilts will be the answer. Somewhere in the middle there is some room for corporate bonds, but they're not the easiest thing to invest in and funds are often counter-productive. Always remember that you can get a rock-solid Government bond from the Post Office and pay no charges at all.

More: Gilts and Corporate Bonds discussion board

A version of this article first appeared in August 2001