How investments work - corporate bonds

I hope you are having a good summer! I have been making the most of the good weather (when we get it in Scotland) and been hacking round the golf course and sea-kayaking. Even managed a sighting of dolphins near Bass Rock.

This episode is on corporate bonds a nice and easy one now that you have got your head around gilts! As I said last time – gilts are great, guaranteed without limit by the UK government but …at the moment offering low returns and in all probability will lose money in absolute and real terms in the foreseeable future.

If you go up the risk scale of investments above gilts the next asset you come to is corporate bonds and that is what we are looking at in this episode. As always there is a transcript of the podcast on the web at poundsshillingsandsense.com.

Just as governments need to borrow money, so do businesses. They can, of course, go to the bank and ask for a loan, but they might be charged high interest rates it can be cheaper for companies to raise funds directly from investors. That way the investor can get a higher interest rate than from deposits and the company can pay lower interest rates for its borrowing by cutting out the bank in the middle.

Corporate bonds are similar to gilts because they are fixed interest investments, the rate will not vary after it has been issued. They have a maturity date when you will be repaid and just like gilts they are tradeable after they have been issues and behave in much the same way. The interest is also called a coupon and it is based on the face value or nominal value of the bond not the trading value of the bond.

With corporate bonds instead of lending money to the Government as you do with gilts you are lending money to a business. Whilst the government guarantees to repay you companies do not! This is where they differ from Gilts. So remember what I said in the last episode about higher risk means high rates and lower risk means lower rates. Corporate bonds are more risky but not as much as shares.

Corporate bonds can be secured or unsecured. A secured corporate bond is backed by a specific asset and that means it is more protected than an unsecured one which has not such protection. If a company goes bust it must repay its debts first in the winding up process. This means that corporate bond holders rank ahead of shareholders in having a claim against any assets. Hence bonds are less risky than shares.

If you were lending money to a business that had no assets like a tech company and it had a management team with a poor track record of delivering profit… it might not be the safest thing to do with your kid’s inheritance. If on the other hand the business was a global multinational company employing hundreds of thousands of people and had a “triple A” credit rating (see below) that would be different.

You need to look at the specific terms on each bond to understand the terms and conditions.

Gilts are backed by the Government, while corporate bonds are backed by the company. Therefore the credit-worthiness of the company is vitally important. You are risking not just your interest but also your capital, as a company might “default”, that is, fail to pay the interest in full and in extreme situations fail to pay you back your money. The shorter the term of the corporate bond, the lower the rate of return because there is a lower risk of default. You need to be careful about who you lend money to, which is why credit-worthiness is really important and it is measured by credit ratings agencies. This is much the same as you having a credit score. If you have borrowed money and repaid it – that improves your credit score. Having assets which can provide collateral also improves your credit score. In fact the best credit ratings are usually given to people who have absolutely no need to borrow. I remember a good friend of mine who had always been prudent with his finances, never borrowed, never had a credit card, never had money problems, saved up for anything he bought – could not get a credit card because he had no credit score!

In the nineteenth century there were a lot of companies building railways in North America and investors wanted to avoid losing their money if these companies went bust (which a number did). Henry Varnum Poor published analyses of the financial health of railway companies. The information he provided allowed people to assess how creditworthy the businesses were and this gave birth to the first credit rating agency. It eventually became Standards and Poors.

Today there are three major agencies: Standard and Poor’s (S&P), Moody’s and Fitch. They each provide a ranking of credit-worthiness. You will probably have heard of “AAA” credit ratings, which are the highest credit rating that can be given. Both countries and companies are credit-rated. The former are called sovereign credit ratings and the latter are corporate bond ratings. The S&P AAA rating means that the country or company has an “extremely strong capacity to meet financial commitments”. What does that mean? It means that it is very safe, but not guaranteed. The ratings are not an indication that you should buy (or sell) investments. There are a range of credit ratings: AAA, AA, A, BBB, BB, B, CCC, CC, C and D. In the world of investment, BBB and above are termed “investment grade”, while ratings below that, i.e. BB to D, are termed “junk” status. The lower the credit rating, the higher the interest rate that the company or government needs to pay to encourage investors to lend them money.

If you are lending money to a company with a credit rating of AA you will not get as high an interest rate as you will from lending money to a company with a credit rating of BBB. A loan to a company with a BBB rating is higher risk and that risk is compensated for with higher interest. Clearly, though, you would expect a company with an AA rating to be safer than one with a BBB rating and you would run less risk of losing your money. But be warned credit ratings are not guaranteed, just “best guesses” – Standards and Poors rated Lehman Brothers as A – investment grade up till six days before it collapsed.

Hopefully, you remember our friends the FSCS (Financial Services Compensation Scheme). They pay compensation if a bank or building society goes bust. There is no such protection for corporate bonds.

A lot of people have found out this lesson the hard way recently. Over the last few years a number of companies having been marketing their corporate bonds in similar ways to bank and building societies marketing their deposit accounts. It hasn’t helped that the word “bond” is used to describe fixed interest deposit accounts as well as loans to companies. It was almost inevitable that this would lead to confusion which would be exploited. With interest rates at historic lows people were offered returns of 8% a year or more. You cannot get a quart out of a pint pot. You cannot get returns better than shares, which are risky, by investing in a safe, risk-free investment. It just doesn’t happen. The higher rate tells you that there must be greater risk so you absolutely need to do your homework or better yet, talk to a qualified adviser.

If you can lose your money by investing in a corporate bond, then why not stick to gilts? They are, after all, backed by the Government and as guaranteed as you can get. The answer is to compare the gross redemption yields on offer between gilts and corporate bonds. Once you have the yields to compare you can assess whether or not the additional return from a corporate bond is worth the additional risk. In general a triple “A” government bond will never pay as high a return as a triple “A” rated corporate bond. The difference is called the “spread” – it is the “gap” between the returns on gilts and corporate bonds. You might call it the “risk premium”.

Hopefully you remember from the last episode that you can make a profit on gilts if interest rates fall after you have bought them. As interest rates go down fixed interest investments tend to go up in value. This applies to corporate bonds as well. But there is also more potential to make capital gains on corporate bonds if a company is re-rated. If a BBB rate company issued a bond paying 6% interest when AA companies were typically paying 4% and then that company had a magical upgrade from Standard and Poor’s making it AA, you would expect the price of that corporate bond to go up and the yield to fall. Conversely, if a company is downgraded, then the capital value of their corporate bonds would fall. Credit ratings of countries do change but they do so far less often and rarely in big jumps so those sorts of gains and losses are much rarer on gilts.

In normal circumstances government bonds/gilts are easily bought and sold – there is never a serious issue of no-one wanting to buy them. With corporate bonds it can be different. There may be occasions when a company is facing a tough trading environment and few if any potential investors want to buy their bonds. This can result in what is called a “liquidity” problem – in other words you may not be able to sell your bond at anything like a sensible price. I covered this in the episode on “What an investment is actually worth” so if you have forgotten - you might want to refresh your understanding! There is a library now of past episodes on the website to help and the transcripts are still there to read at your leisure.

As always – if you like what you’re hearing tell your family and friends and if not – tell me!

I am still looking for people to interview – if you think that could be you then get in touch through the contact page!

Next time I will cover off shares and how they work, till then thanks for listening