Corporate bonds are far more complex than most investors realise and in order to choose the best one, both the type of bond and how you access the asset class need to be taken into account
Corporate bonds have topped the Investment Management Association sales tables for most of the year.
Many investors see bonds as one step up the risk ladder from cash, with corporate bonds at the riskier end of the bond spectrum but still relatively safe – if a company folds, bondholders are ahead of shareholders in the queue for remuneration.
But it is much more complex than that. Corporate bond risk depends on the bonds you buy and how you access the asset class.
Bond pricing is principally affected by investor perceptions regarding risk. Two key factors are the creditworthiness of the borrower and the timeframe till maturity.
Creditworthiness
Major developed country bond markets are regarded as risk-free and generally this ‘risk-free’ rate, (commonly) defined by the 10-year part of the curve, is regarded as the key benchmark in the appraisal of other investment opportunities – the key discount rate.
If governments of industrialised nations are unlikely to default, the same cannot be said of the corporate sector. The question for putative investors is how much more a company should pay to seduce them out of the security of government debt.
The ratings agencies give a guide as to how confident investors should be about the borrower’s ability to repay – with the top rating being AAA and most investors losing interest once ratings fall below BBB.
Maturity
Institutions wish to borrow over a variety of timeframes – from a few months to as much as 50 years or more. Under normal circumstances the compensation that investors require will be higher as the maturity dates extend into the future.
This tension between maturity and creditworthiness is worked out in the market and resolves into two curves that bond investors watch closely: the government yield curve (figure 1) and the spread curve (figure 2).
Investors generally earn more the longer the timeframe and the weaker the credit.
At the 10-year part of the curve, single-A-class bonds are offering returns of around 5%–6%. BBB-class bonds will come in at around 6%–7%.
Two yields are frequently quoted to investors: the income or running yield and the gross redemption yield (GRY).
The first is simply the coupon divided by the price of the bond. If a bond is issued at 100 at a coupon of 5% then the running yield is 5/100 – ie 5%. If the same bond is bought for 105 then the running yield is 5/105 – 4.76%. But this is where life gets more difficult. As all bonds are repaid at par (100), the above example would show a 5% loss of capital at redemption. So what is the true yield? This is given by the GRY, which accounts for capital loss or gain at maturity. This is the metric that investors should keep in view emphatically.
Interest rates and inflation are key factors that will determine the price investors will pay for bonds on the secondary market. Price changes can be significant, and investors should make themselves aware of this risk.
Take two bonds – UK gilt 5% 2012 and UK gilt 5% 2025.
If yields rise by 1%, the value of the former moves from 99.99 to 97.62 – a negligible change. The same change in yield for the latter would take the price from 99 to 87 – a much bigger percentage loss.
It is important therefore to be invested in the right part of the yield curve ahead of expected changes in interest rates and yields, and for this reason the default for most private investors is at the short end of the curve.
Access
If you hold single issue bonds from issue till maturity the complexities of bond pricing will probably have little effect on you. But few investors do.
Many access the asset class through managed bond funds (thereby enjoying the benefits of active expert management, reduced risk and liquidity), but these funds can be expensive in the retail space – often with as much as a 5% initial charge and a 1.5% annual management charge – and your capital value may go down, as you are buying a basket of traded assets subject to market movements.
There are other ways of investing in bonds worth considering.
Buying direct
If you buy direct, you have the ability to lock into a fixed-term, fixed-rate deal. So, for instance, in mid-February Tesco offered a five-year bond with a 5% coupon. Investors bought it knowing they should get their money back in five years and 5% p.a. every year in the meantime – the classic predictable attributes of a bond that most people recognise.
However, most of these attractive companies require a minimum investment of £50,000 – they argue that to issue in smaller denominations they would have to issue a full prospectus incurring greater expense. And within a smaller portfolio that can focus risk.
Segregated portfolios
To reduce risk, investors need to build a portfolio of bonds – or to pool their assets in a small, segregated portfolio with other investors who have similar investment objectives, similar needs in terms of timescale and income requirement and similar risk attitudes.
A high-quality, short-dated bond portfolio will protect investors from unexpected changes in interest rates and inflation expectations. In the event of adverse changes in markets, investors have the option to hold their bonds to maturity.
Investors should consider ‘liquidity risk’ – that is, the ease with which assets, including bonds, can be bought and sold in the market. This is less important if bonds are held in redemption, but when asset markets froze in 2008 certain types of bonds and maturities were much harder to trade than others.
Exchange traded funds
While direct portfolios allow investors to control credit and duration risk, ETFs exchange some loss of control in return for greater diversification and therefore increased protection from default. Another attraction is their low costs.
The risk here is that a severe change in the interest/inflation outlook can lead to a rapid change in the value of longer-duration securities. Thus, as with managed bond funds, there is usually greater diversification but generally increased price risk. Investors lose the capacity to hold out to maturity and the ability to tailor the cashflows to their own needs.
The risks associated with bonds are more complex than many investors assume.
They should consider carefully how they access the asset class. For many, a combination of segregated bond portfolios, individual bonds and bond ETFs may offer the best solution – allowing investors to tailor the risk profile of their bond portfolio to suit their objectives with maximum diversification benefits and lower costs.
Paul Wharton, investment director and portfolio manager, Deutsche Bank Private Wealth Management
