A beginner’s guide to investing in corporate bondsHampton Wealth
Corporate bonds. They’ve been considered among the most promising financial investments out there for those who are looking for an effective and lucrative alternative to buying shares.
They are also great if you’re looking for a starting point into investing in businesses. Companies issue these corporate bonds, and these essentially work as IOUs from businesses that need extra funding.
As a popular investment option, beginners are often encouraged to learn as much as they can about corporate bonds, either as a way to kick off their investment journey or to begin diversifying their portfolios.
With that, here is a short guide for the new guy (or girl), exploring the basics of corporate bonds and how to go about investing in them.
What are corporate bonds?
Corporate bonds can be looked at the same way as loan agreements or as IOUs from a business that needs to borrow money. They turn to investors for that extra funding, and the aim is to gradually pay back interest on this accumulated debt at half-yearly intervals.
Eventually, capital is returned once the bond has matured. That’s the simplest way to put the corporate bond process into words. However, bonds are generally comprehensive investment vehicles with many aspects that may seem quite complex to beginners.
The corporate bond market is a colossal juggernaut, considered one of the hugest markets in the world with an estimated total value of $9.77 trillion (that’s almost 25% of the entire U.S. bond market during the start of 2014). One prominent reason why the corporate bond is so appealing to the average investor is simply due to security. Many experts consider corporate bonds safer than stocks and, in most cases, they pay interest that’s higher than the interest from government bonds.
How does it work?
First of all, when you buy corporate bonds, know that the IOU comes with a specified term and once it matures (usually in five or ten years) the invested sum is returned in full. The only way that this process is disrupted is if the company actually goes bust.
When a person opts for a corporate bond, he/she is supposed to get a coupon that states the amount of interest to be paid. Essentially, the coupon acts as a fixed percentage of the cover price of the bond (for instance, an interest rate of 5 per cent). For as long as a person holds onto that particular bond, the coupon will be issued on an annual basis. Hold on to it until maturity, and he/she should be able to get the capital back.
Here’s a simple example for a clearer picture: Let’s say someone buys a ten-year bond worth £10,000 at a 5 per cent return. This means that the person can expect to get £500 worth of interest each year, and to (after about ten years) get the £10,000 back (the original invested capital).
Safety is determined by the company issuing corporate bonds
The safety of a corporate bond also depends heavily on the issuing company’s credit ratings. If a company has excellent to low credit ratings and is issuing investment-grade corporate bonds, then there are typically lower interest rates brought on by the safety of the investment.
On the flip side, companies with weaker credit ratings issue bonds with higher interest rates in order to reflect the level of riskiness and to protect investors. If the company actually makes good on the bond, then naturally there is a larger payout and investors can benefit.
What’s the difference between corporate bonds and fixed-rate savings?
For the most part, there are quite a lot of similarities between how corporate bonds work and how fixed-rate savings accounts (or even a savings bond) work. There are, however, a few key differences.
A bond is an investment and not a savings product. This means that it’s not covered by the Financial Services Compensation Scheme’s £85,000 individual savings protection cover.
Also, market-traded corporate bonds are actively bought and sold, so the price should change with the market throughout its lifetime. This means that if a person holds a ten-year corporate bond, he/she doesn’t necessarily have to wait for ten years to cash in (the bond can be sold at any point). That’s a key difference between the corporate bond and fixed-rate savings.
However, this also all means that a bond’s safety is determined by the issuing company,so there is an aspect of risk. This is why smaller, more risky firms often have to offer higher rates to draw investors in.
Buying and selling corporate bonds
Between a corporate bond’s issue and maturity date, its price may rise and fall at any point in time. Therefore, selling a corporate bond before it matures could result in either a substantial gain or an unfortunate loss. That’s part of the risk that has to be accepted.
If a person decides to sell the bond, it may be worth less than what was paid for it.
On the other hand, it can also be worth more, and a person might even be able to make a capital gain on the investment altogether.
If a bond is trading above its initial level, that’s called trading above par. If it’s trading below its initial level, it’s called trading below par. If a corporate bond is purchased second-hand, then a person has the right to be repaid its value once maturity approaches (along with the coupon interest rate). However, if a person pays above or below par for the bond itself, then this might change the income return.
Traded second-hand bonds usually come with a quoted yield to maturity. If someone purchases a bond at a discount, the yield to maturity should be higher (when compared to the original coupon).
If the bond is purchased above par, the yield to maturity should be lower.
A person could opt for a bond fund manager
Instead of directly investing in corporate bonds as an individual investor, a person could also buy corporate bonds through funds. These bond funds make multiple investments in a number of different firms, effectively distributing the risk across many options and increasing safety. The bond fund manager aims to take advantage of swings in the market. In this way, the manager can deliver returns through the income from the bonds that are held in the fund as well as from the added value from buying traded bonds below par or selling them above par.
There are certain things to take note of. A person has to pay management fees and, on top of this, the value of a corporate bond fund is largely determined by its varied holdings.
This all comes down to the skill of the fund manager. If the manager makes a bad call and buys bonds from a company that folds, the fund can lose money. However, if the manager builds a good portfolio, the bond fund could rise in value due to nifty trading. In this case, a person can expect solid income returns and optimal capital growth.
Bond funds also spread risk throughout many different companies, so they are relatively safer than going at it alone, particularly if a person isn’t an experienced investor.
Financial advice can help. Although corporate bonds are safer than many other investment vehicles, at the end of the day they are investments and not a savings product (which means that some risk is carried either way).
If you are sick and would get a consultation from a proper and qualified doctor, do the same for your financial health checks. We at Hampton Wealth are experienced in providing high quality advise and selection of funds to cater for you and your family’s needs.
Hampton Wealth specialises in sourcing high quality, listed bonds and funds with a focus on providing returns in excess of normal off the shelf investment options.
Find out more at HamptonWealth.com