The party's over for corporate bonds

Better late than never. Having watched retail investors pile into corporate bonds 2009's most popular investment sector, according to the Investment Management Association the London Stock Exchange has joined the party. It has created a retail platform designed to make trading corporate bonds as easy as trading listed shares. And it's a great idea in principle. The trouble is, now's not the time to buy corporate bonds. Here's why.

Corporate bond basics

Firms that want to raise cash by borrowing have two options. The first is a bank loan. But a cheaper bet, for big firms in particular, is to issue corporate bonds. These are tradable IOUs. Each represents a fixed (nominal) amount of a firm's total borrowing. Generally, they're issued direct to institutional investors. They can then be traded just like shares. The return for an investor (or yield, see page 49) comes in two forms: regular interest income and a capital gain if they buy a bond for less than they paid. But unlike shares, bonds usually have a fixed redemption date, at which point they are bought back by the issuer. The original loan is then paid off. The good news for investors is that should a firm get into trouble, corporate bondholders come higher up the queue for repayment of their capital than shareholders do.

What is the LSE offering?

Until now buying corporate bonds has been a bit of a minefield for retail investors. There is no central market, such as a stock exchange, for bonds. So retail investors have to find a broker who deals in the bonds. And trading costs and bid-to-offer spreads can vary wildly on different bonds. In short, the market is a bit of a "wilderness", as Nick Louth puts it in the FT. Moreover, quite a few bonds can only be traded in large deal sizes a £10,000 minimum isn't uncommon.

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Enter the retail bonds platform. Ten corporate bonds are now available, issued by blue chips such as Tesco, BT, National Grid and GlaxoSmithKline. One bond on offer from RBS has even been launched with this service in mind. It has a ten-year duration and offers a fixed coupon of 5.1%. You can also buy or sell a range of gilts (UK government IOUs) through the platform. The good news is that the corporate bonds can be bought in increments of just £1,000, or in some cases less, while gilt deal sizes can be as low as £1. And because certain brokers, such as Evolution Securities and Shore Capital, have committed to act as market makers (see page 48), the bonds should always be tradeable throughout the normal LSE day. So what's not to like?

There are two reasons to be wary. Firstly, the service still has big limitations. Although 11 brokers have signed up to support it, some big names remain absent. These include Barclays Stockbrokers, which runs one of the biggest retail corporate bonds lists. And ten bonds is not a lot to choose from. Combine that with the lack of market makers and, inevitably, prices are high.

Watch out if the party stops

But these issues can be resolved. The real problem for us is the timing. Corporate bonds have been on a roll recently. With the Bank of England base rate at a record low, the promise of a decent yield from corporate bonds has seen investors pile in. But that in turn has depressed yields, meaning investors are having to seek out riskier bonds to match the returns available on the safer paper six to 12 months ago. And make no mistake corporate bonds can be risky. In the worst-case scenario an issuer can go bust, leaving investors empty handed. There's also the danger that interest rates could rise, which would depress bond prices (see the below).

What to buy instead

In short, if it's a low-risk income you're after, it's hard to see why you would pick the LSE's corporate bonds over, say, a Birmingham Midshires savings account paying 5.1% gross over five years. Or, if you can accept a little more risk, go for shares in blue chips with decent cash flow. Power firm National Grid (LSE: NG) offers a forward yield of 6.5%, while insurer Royal Sun Alliance (LSE: RSA) is on 6.7%.

What happens to bonds when interest rates rise

Bond prices and interest rates tend to move in opposite directions. That's because most bonds (including most gilts) pay a fixed annual income. So a 6% bond issued now with a ten-year life until redemption will only ever pay its holder £6 a year.

Given any investor could put their money into a bank account with a variable rate of interest, bonds need some way to stay competitive if the Bank of England base rate (and so commercial bank interest rates) start rising. That's why the price changes.

For example (ignoring considerations such as default risk), let's say you had a choice between a 7% deposit account and a 3.5% bond priced at £50. You should be indifferent as to where you invest £100 (the deposit offers 7%, or you can afford two bonds each paying £3.50). But if the bank deposit rate jumps to 10%, 3.5% bondholders will start selling out of bonds, pushing the price down. Once it reaches about £33, it should stop. That's because £100 now buys you three bonds, each paying a £3.50 coupon, similar to the £10 you could now get from a bank. The reverse is true if the bank rate drops.