What you should know about corporate bonds

Demand for many investments has suffered in the wake of the financial crisis. Investors, wary after suffering two big bear markets in just over a decade, are putting less money into shares. Property continues to fascinate, but sales have halved compared to the pre-crisis days.

But one asset class has seen interest boom among private investors. We're talking about corporate bonds.

This demand is partly because the market has been opened up to smaller investors. And it's partly because investors are desperate for income, which is a key attraction of bonds.

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One thing's for sure, companies are taking full advantage. It seems that almost every week, another company launches a new bond for investors to buy.

So today I want to look at how corporate bonds work, so you can navigate this market with more confidence.

What are corporate bonds?

All businesses need money to fund themselves. This can come from the owners of the business (shareholders) in the form of equity, or it can be borrowed.

Lots of companies borrow money from banks, just as we might do if we wanted to buy a house or a car. But there is another option open to them as well.

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Companies can also borrow money from investors. They do this by issuing bonds that can be traded on the stock exchange. Because these bonds are issued by companies, they are called corporate bonds. (Governments borrow money this way too, but we'll look at that another time).

Say a company wants to borrow £100 million. What it will typically do is divide this amount into individual bonds - IOUs basically - of £100, which investors can then buy. It will offer to pay a rate of interest - say 6% - on these bonds, every year for the next ten years. At the end of the period, it will pay the £100 back.

Clean and dirty prices

Before a corporate bond begins trading on the stock exchange for the first time, it usually has a starting value of £100. This is known as its par' value. When a bond has a price above £100, it is trading above par'. A price of less than £100 is referred to as below par'.

Bond prices move around for lots of different reasons, which we won't get into here. But when you are buying a bond you need to be aware of how much you will actually pay for it.

For example, say our 6% bond above starts trading on 1 January at £100. It pays interest (known as a coupon) of £3 twice a year: once at the end of June, and once at the end of December. At the end of March, you decide to buy the bond. You have a look on your broker's website and see them quoting a price of £100. But when you buy the bond you find out that you have paid £101.50. Why is this?

Well, it's due to what's known as accrued interest. If you buy the bond between coupon payment dates, the seller of the bond is entitled to his share of the interest accrued over the period.

Because March is halfway through the six-month payment period, the seller would be entitled to £1.50 of interest (£3 x 3/6). So the £100 quoted on the broker's web site is the clean price. The £101.50 that you actually end up paying is known as the dirty price. This is made up of the clean price plus the amount of accrued interest.

How bond yields work

Just like shares, it is possible to make money by buying bonds at a low price and then selling them at a higher one. But one of the main reasons people buy bonds is to get a reliable source of income.

You can compare a bond's income with a savings account, another bond or the dividend income on shares, by calculating a simple income yield.

Let's stick with our 6% bond as an example here. Say the price has gone down to £90. The income yield is simply your annual coupon of £6, divided by the current price of £90, which comes out at 6.67%.

There's another measure of yield, which is also very useful. It's the redemption yield or yield to maturity. This calculates the annual return that you will make if you buy the bond today and hold it until the end of its life, when the company pays back the £100 it initially borrowed.

Take the price of £90 and assume that the first £3 coupon has just been paid (so the clean price' is the same as the dirty price'). If you buy the bond and hold it until the end of its life, you will receive all the remaining coupons, plus £100 back.

You can calculate the redemption yield in a spreadsheet (using the IRR function) if you want to, but these yields are quite readily available on corporate bond websites, so you don't have to do it yourself.

In this example, the redemption yield is 7.44%. This is mainly made up of the income yield of 6.66% and the fact that you make a capital gain at the end of the bond's life - remember you bought the bond for £90 and the company pays you back £100.

Safety checks for corporate bonds

Like every investment, you want to make sure that you will be able to sleep at night if you buy a corporate bond. So what safety checks do you need to carry out?

It's always a good idea to look at what the business issuing the bond actually does. Do you understand it? Will it still be around to pay your money back in ten years' time?

However, the most important thing to work out is the company's ability to pay you your interest on your bonds. To figure that out, you need to look at the amount of money the company is making. Does the company have enough profits to pay its interest bill?

You can work this out by calculating a company's interest cover. You take its operating profit figure and divide it by the total interest payable. The higher the number you get, the safer your bond usually is.

Of course, working out whether a bond is a good investment or not involves making a few more calculations than this. But hopefully, this introduction should have given you a good understanding of how corporate bonds work. We'll get on to valuing them in more detail in a future article.

This article is taken from our beginner's guide to investing, MoneyWeek Basics. Everything you need to know about how to invest your money for profit, delivered FREE to your inbox, twice a week. Sign up to MoneyWeek Basics here .