Corporate bonds play an integral part in many investment portfolios. This is partly as a diversification measure to lower overall risk, but also, in many cases, to provide regular in
Corporate bonds play an integral part in many investment portfolios. This is partly as a diversification measure to lower overall risk, but also, in many cases, to provide regular income. Bonds generate a natural income, which means you can receive regular payments without touching the capital. They also have the potential to provide capital growth over the longer-term, helping you keep pace with inflation.
The Eurozone debt and economic fears over the last few months have impacted on many investment values as investors moved capital to what they perceive to be safer assets. However, because of the way bonds work, the rate of interest holds up even when values fall, so the income stream is likely to not be impacted.
Interestingly this situation is beneficial for people buying bonds now.
Why?
Most investors buy bonds via a fund. A well managed bond fund will invest in a wide range of bonds, depending on its mandate. Companies raise money by borrowing from investors over a fixed term and at a fixed rate of interest. A bond is usually issued at 100 Pounds or Euros; will pay a fixed level of interest each year and at maturity will repay the original issue amount (provided it does not default). In the interim, the bond can be traded and as such it has a current market value.
We are currently in a situation where bonds are being valued at significantly less than their issue price.
To illustrate this by way of an example, a bond is issued for a fixed term of five years with a fixed interest of 6% per annum. If during the term its market value falls by 10% of what it was issued at, for new investors this means that the bond can be purchased at that lower price with an effective yield of 6.67% per annum. Then at maturity it would have increased in value back to its maturity price, therefore giving an additional capital gain of 10%. For those original investors, they would get back their original investment amount and would have received a yield of 6% p.a.
So although there may be further volatility in the short term, investors currently have an opportunity to enjoy high income yields at reduced prices.
Bond fund managers actively buy and sell bonds where they see opportunities to make gains by doing so. With the current low values available, it is possible for fund managers to make significant gains on some bonds if they buy them today and hold to maturity.
So what can go wrong?
The major risk to investing in bonds is that the issuing company defaults on either paying interest or capital at maturity.
Should a company go bankrupt bond holders rank higher in the pecking order than shareholders in respect of entitlement to the company assets.
Experienced bond fund managers evaluate companies closely, with the objective of staying away from companies which may default on their bonds. They also believe that corporations are well prepared for the current environment, earnings continue to be sound and companies are deleveraging.
Different types of bonds
Government bonds – known as gilts in the UK or Treasury notes/bonds in the US. These are bonds issued by a government in its own currency. Bonds issued by a national government in a foreign currency are known as sovereign bonds. Investors consider these the safest type of bond, as the national governments of most modern developed countries are considered to be almost “risk-free” from a default point of view.
Corporate bonds ? debt securities issued by companies and sold to investors. Along with loans, this is a major source of capital for many companies. The issuers are grouped by their credit rating. Higher quality bonds are considered ?investment grade? whereas those with a perceived higher risk are called ?high yield.? Corporate bonds are considered higher risk than government bonds and as a result usually always have a higher rate of interest.
High yield bonds are currently trading at cheap levels, both to their fundamentals and to an extended global slowdown. Many managers expect strong returns in the medium term, these should be well in excess of government bonds and cash returns (though with higher risk). It is anticipated that defaults should remain low.
While the macroeconomic picture does remain unclear, the consensus view is that the market has more than discounted the most likely outcome. Exceptional value is available and there is the potential for yields well into double figures.
As always, while bonds look attractive right now, it is not recommended that you pile all of your money into bonds. The tried and tested route of asset allocation remains as important as ever ? probably more so in these difficult times. You should always discuss investment opportunities with a financial adviser to ensure they suit your objectives and circumstances and work well with your other assets.
These views are put forward for consideration purposes only as the suitability of any investment is dependent on the investment objectives, time horizon and attitude to risk of the investor. The value of investments can fall as well as rise as can the income arising from them. Past performance should not be seen as an indication of future performance. You should seek advice from an authorised financial adviser such as Blevins Franks Financial Management Ltd.
Blevins Franks Financial Management Ltd is authorised and regulated by the UK Financial Services Authority for the conduct of investment and pension business.
By Bill Blevins, Managing Director, Blevins Franks
24th October 2011
