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.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
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.
MoneyWeek videos
Bond basics: corporate bonds
Tim Bennett explains the basics of corporate bonds: why companies issue bonds, what affects bond prices, and the key risks associated with them.
Watch all of Tim's videos here
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 .
-
Adidas, Nike or Jordans - could collectable trainers make you rich?The right pair of trainers can fetch six figures. Here's how you can start collecting vintage Adidas, Nike or Jordans now
-
Early bird ISA investors flock to global funds, India and the USThere’s been an increase in investors maxing out their ISA at the start of the new tax year. But where are they putting their cash and why does it make sense to be an early bird investor?
-
A beginner’s guide to bitcoin: what is bitcoin?Beginners' Guides As a completely novel concept for many people, bitcoin can take a little effort to get to grips with. In the first of a short series on the cryptocurrency, Dominic Frisby explains just what it is, and why you should take notice of it.
-
Here's why the market is irrational – it's the City's faultBeginners' Guides The trouble with the financial services industry is that it is not interested in making money for you. It is interested in making money for itself. The best person to manage your money is you, says John Stepek. Here's why.
-
Portfolio building: How to go it alone and do it yourself
Beginners' Guides So you’ve decided to take charge of your own money. But before you invest a penny, you need to think about how you are going to put together your investment portfolio.
-
How do you know when a market is cheap?
Beginners' Guides The way to make money from investing is to buy when markets are cheap and sell when they're expensive. Here, John Stepek explains one simple way to tell when that is.
-
How to value companies that own lots of assets
Beginners' Guides For some asset-rich companies, it's not necessarily their earnings that makes them attractive investments, says Tim Bennett. Here, he explains the best way to work out how much you should pay for them.
-
How you can get an investing edge over the professionals
Beginners' Guides When it comes to research, most professional investors are lazy, says Phil Oakley. Here, he explains how spending a little time getting to know a firm's annual report can earn you big profits.
-
Three vital things you must know about commodities
Beginners' Guides 'Real' assets are popular with investors at the moment. But what are they and how do they fit in to your portfolio? John Stepek explains.
-
What’s so important about gold?
Beginners' Guides Once dismissed as primitive and irrelevant, gold has been rediscovered by investors. Little wonder, says John Stepek. Here, he explains why gold is an essential part of your portfolio.
