We take a look at corporate bonds, explaining what they are and how you can profit from them.
Here at the Fool, our investment ideas tend to focus on shares. And that's not surprising, since over the long term they've been shown to outperform other asset classes.
But other investments can also have a place in your portfolio, and one that's looking increasingly interesting at the moment is corporate bonds.
What are they?
Corporate bonds are loans made to companies, and these loans can be bought and sold in a similar way to shares. Unlike shares, bonds don't entitle you to any ownership of the company, and you receive interest on the loan, rather than a dividend. While a company can decide not to pay a dividend to shareholders, defaulting on the interest can force it into administration, Woolworths being a recent example. Think of bonds as safer than shares, and riskier than cash.
It works like this: When a company issues a bond, it commits to pay a fixed amount of interest each year, say £8 on a £100 bond. Regardless of how the bonds are subsequently traded in the market, the company will continue to pay this 'coupon'. So even if the bonds are changing hands for £110, the owners will still receive £8 -- i.e. the yield will have fallen from 8% to 7.3%.
The 7.3% in this example is the 'flat yield', the coupon divided by the market price of the bond. But when the bond is due to be repaid, or 'redeemed', at some time in the future, the company will only have to pay out the face value of the bond, £100. Taking that into account gives us an adjusted yield figure, known as the 'gross redemption yield'.
A key point to remember here is that the payout is constant, so as the price of the bond rises, the yield percentage falls, and vice versa. If you bought when the yield was 8%, and it fell to 4%, the value of your bonds would have doubled.
What drives the prices and yields?
Obviously, lending money to a company is more risky than lending it to (most) governments, so you'll require a higher yield in return. Therefore you can think of the yield as being made up of two parts:
- the official government interest rate, which is essentially risk-free; and
- a premium for the riskiness of the company.
What's in it for me?
This is where it gets interesting. Currently, interest rates are at historical lows, and this would tend to push bond prices higher; conventionally, not a good time to buy. On the other hand, economic news has made investors increasingly cautious, so they regard company debt (and shares) as particularly risky, and require a bigger premium for holding it.
This premium, or 'yield spread', is at its widest for a very long time; some say it hasn't been this wide since the Great Depression in the 1930s, although I haven't been able to verify this. But clearly, people are very scared, and the price of lower-risk bonds has fallen nearly 30% over the past three years.
How to buy
Individual bonds can be difficult to buy in small amounts, although some are available. Spreading the risk by buying a fund is also more convenient, and there are plenty of unit trusts happy to charge you 4% up front and 1% per annum for the privilege, but personally I wouldn't touch them.
In my opinion, the best way to get exposure to bonds is through the iShares Corporate Bond exchange traded fund (LSE: SLXX), which has no up front fees, and an annual cost of 0.2%. While corporate defaults are forecast to rise considerably this year, this ETF focuses on companies with better credit ratings (albeit many banks), and has a gross redemption yield of 8.7% assuming no defaults.
Buffett's policy of being greedy when others are fearful needn't just apply to shares. If you believe the current pessimism is excessive, and you're taking a long-term view, this could be a great time to buy bonds.
More info: Avoiding The Corporate Debt Nightmare | Bond & Gilts Discussion Board
iShare funds and other ETFs can be bought for as little as £1.50 using the Motley Fool Sharedealing Service.
