Investment Advice

Corporate Bonds explained

Fixed interest securities represent a major asset class, and particularly at times when equities are highly volatile, which will appeal to many investors.  Corporate bonds are fixed interest securities issued by companies and are in effect loans to the issuing company by those who initially take up the bonds. The bonds can then be traded on the market. Corporate bonds are generally higher risk than gilts, but offer some attractive opportunities at times. For companies, issuing bonds may prove attractive if bank lending is difficult to obtain, and often represents a cheaper source of borrowing than banks. However, investors will only be attracted if the company is credit worthy and if the potential return justifies the associated risk.

Bond Returns

A corporate bond pays a fixed rate of interest (coupon) in much the same way as a gilt. The coupon measures this income as a percentage of the nominal value of the bond. The nominal value of the bond is its redemption value. However, generally, the current price of a bond in the market is different from its nominal value, so it is important to consider the actual return the investment offers, rather than just the coupon.

For example, consider a (fictitious) corporate bond issued by XZY plc, with a coupon of 5% per year of the nominal value, so a holding of £10,000 nominal value of the bond would provide an income of £500 per year (usually, but not always, paid in two half yearly instalments). This is the gross income and it is important to note that the income is taxed as savings income and is paid after deduction of 20% tax at source. Obviously, if a company was making the investment, any tax due would be at the company corporation tax level for both income and capital gains.

Where the bond is purchased on the market, its price will depend on a number of factors, which I will cover later, and may be more or less than the nominal value. Suppose that the current market price of a holding of  £10,000 nominal of XYZ plc bond is £10,800, the coupon is 5% but the actual yield to the investor will be less, because he has paid more than the nominal value.

The income yield (also known by a variety of other names, including the running yield or income yield) measures the income as a percentage of the purchase price. In this case the interest yield would be:

£500 x 100 = 4.630%
£10,800

Although the interest yield gives a better indication than the coupon of the actual yield to the investor, it does not give the complete picture. If the investor pays £10,800, and holds the bond until redemption, he will have a certain capital loss of £800, because the redemption value will only be £10,000. This therefore needs to be factored in to the calculation of what is known as the redemption yield.

Redemption Yield

Suppose the redemption date is five years away. One method of approximating the redemption yield is sometimes called the Japanese method, and rests on a simple interest calculation rather than a compound interest calculation. The approach is to take the gain or loss that would occur on redemption and divide it by the period remaining. The result is then used as an adjustment to the interest yield.

In the above example, the loss at redemption is £800, which represents a percentage loss over five years of:
£800 x 100 = 7.407%
£10,800

The adjustment to the annual yield is therefore 7.407% divided by 5 = 1.481% so the approximate redemption yield is 4.630% – 1.481% = 3.149% pa.

A more precise calculation based on the exact timing of each payment to the investor would yield a slightly different result, but generally the difference is not great.  In the example used, if we assume the income payments are half yearly, the actual redemption yield is approximately 3.27%pa, so the estimate give above is quite good.

Points to be aware of

The yield to investors depends on the price of the corporate bond and clearly a major factor affecting this is the level of market interest rates. An investor will only buy a bond if the return is commensurate with that available elsewhere, so when interest rates are high, he will require a similarly high yield from the bond, which implies a relatively low price. In the same way bond prices tend to rise as interest rates fall.

There are however a number of other factors which come into play. As well as interest rates, inflation levels will also affect the attraction of bonds and therefore their price. Because the income derived, and the eventual redemption value, are fixed in monetary terms, their real value will be eroded by high levels of inflation, which will therefore reduce bond prices.

Economic conditions generally will also impact on anticipated interest rates and therefore bond prices. For example, in a conventional economic cycle, a high government borrowing requirement will usually mean that interest rates will rise. In our current economic cycle we have high levels of government borrowing and yet interest rates are the lowest since records began!

The attractiveness of other asset classes will influence bond prices too, because although the market in fixed interest securities is huge, it is still influenced by supply and demand.

The volatility in the price of bonds is generally less than that of equities, reflecting their relatively lower risk nature. In general longer dated bonds i.e. those with the greatest remaining period to redemption, are more volatile than short dated bonds. This reflects the greater impact of market interest rates over the longer period.

Bonds with a relatively low coupon are also more volatile than those with higher coupon, because any movement in market interest rates will have a greater proportionate effect.

Specific Risk Factors

Companies issuing bonds are rated by credit ratings agencies, including Moody’s and Standard and Poor’s. This provides a basis on which investors can get an indication of relative risk and so consider the attraction of a particular bond investment. The greater the level of risk the market feels a particular corporate bond entails, the greater the yield will be and the lower the price.

A wide range of factors are taken into account in the grading, including profitability and cash flow, and the overall extent of borrowing by the company concerned.

Over time, the perceived prospects for a particular company will change, and this will affect the pricing of the bond. If prospects improve, the price of the bond will increase and the yield reduce, relative to the current price (the fixed monetary level of income for an existing investor does not change of course). This creates the potential for a capital gain for the investor; however, there is also the potential for loss if the bond is downgraded and the price falls as a result.

© 2009 Paul Parr – Financial Planner.