By ADRIAN LOWCOCK 09/04/2009
For many investors, corporate bonds are less familiar territory than equities. There have been numerous mentions of them as investment opportunities of late, but rarely, if at all, do we hear of reports about movements in the bond market.
What is a corporate bond?
In this context a bond is a debt. The issuer of the bond, in this case a company, is obliged to pay interest during the lifetime of the bond and/or to repay the capital at a later date, to the holder. It is a formal contract to repay borrowed money with interest at fixed intervals. Corporations can issue bonds to raise money in order to expand its business. The term ‘corporate bond’ is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after the issue date.
Corporate bonds can be secured against certain assets of the company, or unsecured. There are different levels of risk for holding different forms of debt issued by the same company. Corporate bonds in issue can be huge in number e.g. Swiss banking giant UBS has over 50,000 corporate bonds issued and only a few types of (usually country specific) equities. This can make it even more difficult for investors to research and identify the right investment opportunities.
Characteristics of corporate bonds
Corporate bonds are lower risk and traditionally less volatile than equities. As such, their expected returns are lower than for equities. Equally, they are less likely to fall as significantly in value. Income generated by these investments is the main driver of performance and with income being reinvested investors can benefit from them as growth vehicles as well as purely taking income from them.
Historic performance
With the exception of the last 12 months, corporate bonds have provided steady, positive returns over the last 20 years. In comparison, equities have actually provided a similar level of return, although they have underperformed very recently. During that time, equities have had two significant periods of outperformance, the 1996-2000 and 2005-2008 bull markets, followed by periods of significant underperformance However, investing in equities at the wrong time could have significantly affected returns.
Why have income yields have risen?
The income yields on corporate bonds have increased recently making the returns more attractive. There are two main reasons for this:
- Forced selling from investors – In October 2008 particularly, there was a rush to cash-in investments to pay off debts, at which point most of the forced sellers were flushed out.
- Rising defaults –In a recession, more companies will default on their debt repayments and go bankrupt. Most of the defaults will happen at the high yield end of the market. Some investment grade bonds (also called quality bonds) will be downgraded into the high yield sector. Currently default rates are low. However, we feel that an increase in defaults has priced into the market.
Quantitative easing
The Government is pumping £75 billion into the UK economy, with a possible further £75 billion in three months time with the purpose of counteracting the effects of people saving more. The money is being used to directly buy gilts (government bonds) and corporate bonds. By selling gilts to the Government, the retail banks get cash back which they can either lend or use it to invest in other assets such as corporate bonds. The intention is to reduce interest rates - so far it has been met with mixed results. It has provided a floor but not reduced gilt yields. The sum involved (£150 billion) is not small and would match the expected Government borrowing in 2009.
The outlook for corporate bonds
Like many advisers we remain positive about corporate bonds and strongly recommend clients hold some corporate bonds as part of a diversified portfolio. The pros and cons for corporate bonds as an asset class are outlined below:
Pros:
- Differentiation to cash - The difference between interests earned on cash versus that earned on corporate bonds has never been greater - you are in effect being paid a premium to invest in them.
- Attractive valuations - The market has priced in high levels of defaults making the returns look appealing.
- Increased allocations - Fund managers & pension funds have increased their allocations to corporate bonds and as a result cash is flowing into the sector.
- Governments buying corporate bonds and gilts – With the government buying up gilts, the companies holding these will receive cash in return, which they can invest back into the corporate bond market effectively creating new demand.
Cons:
- Limited visibility on UK Gross Domestice Product (GDP) - We cannot see at present how much further economic output has to fall and if things deteriorate it will impact on bond prices significantly.
- Forced selling - There is still some further forced selling that could suppress prices.
- Inflation - If there is inflation it is positive for debt issuers but not so good for the debt holders in fixed interest corporate bonds. At present it is very hard to predict what inflation will be in the future.
All corporate bonds are not the same
Corporate bonds are complex and choosing the right ones for a given set of circumstances is not easy. We would suggest getting exposure to this asset class through funds as part of a diversified portfolio. In particular, we would recommend the following bond funds:
For more information on investing in corporate bonds, please call our Investment Advisers on 020 7891 9999 or email best@bestinvest.co.uk.