How corporate bonds work

If you want to generate a reliable income from your savings, then corporate bonds could be the answer.

In thisvideo, Ed Bowsher looks at how they work, how risky they are, and whether or not theyre a good investment for most people.

Transcript

Let's look at what corporate bonds actually are. If you buy a corporate bond, you're lending money to a company, and the company gives you an IOU in return, plus an annual income. They're very similar to gilts we did a video on gilts recently with gilts you're lending money to the government and you get an IOU in return, and an income. With a corporate bond you're lending money to a company.

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Let's look at a hypothetical, imaginary corporate bond: Tesco, 5.5%, 23 December. This is a hypothetical bond, but let's imagine Tesco was about to issue this bond. If I invested £1,000 in this bond, I'd then get £55 a year each year for the next ten years, and then in ten years' time, I'd get my original £1,000 back.

If I wanted to get my money back before the end of the term, I can go into the market and sell my bond. I won't necessarily get £1,000 back; the market value of the bond might have risen, so I might be lucky and get £1,100 back, or the value might have fallen, and I might only get £900 back. That's very simply how they work.

Now, let's look at the pros. I think the biggest pro of a corporate bond is you get a predictable income. You're going to get that £55 a year pretty much come what may, unless Tesco goes bust and defaults on its debts. That predictability is really nice.

When you compare it, say, with shares, you don't know what's going to happen. You might buy shares in Tesco's now, and there might be a dividend of £30 being paid, but next year, the dividend could be cut to £10 or even abolished completely; you don't know how your income's going to be over the next ten years. With a corporate bond, you've got much more predictability.

Another point is that corporate bonds are relatively low risk. We could call it sort of low-ish risk, or maybe medium-risk, depending on which corporate bonds you're talking about. That's because if a company goes bust, corporate bond holders are higher up the queue for their money than shareholders; if a company goes bust, shareholders are almost certainly not going to get any money, but the corporate bond holders might at least get some of their money back.

I think the other big plus point for corporate bonds is that they've performed really well in recent years. Barclays has done some research comparing the performance of different assets, and in 2012, if you'd invested in a basket of UK corporate bonds, you'd have got a return of 12.1% over the year, plus inflation. Whereas if you'd invested in a basket of UK shares, your return would have been 8.7% plus inflation, so there have been good returns in recent years.

That kind of leads onto the cons for corporate bonds. The big problem with corporate bonds is potentially you can get caught out if inflation or interest rates start to rise in the wider economy. Right now, that £55 a year on £1,000 looks rather nice. Let's say in seven years' time interest rates are higher, and a savings account might pay 7% a year £70 a year.

You might think, "Actually, I wish I had my money in a savings account", but you're stuck with the £55 a year with the corporate bond. I think that's why I think potentially corporate bonds look rather expensive at the moment.

They've done really well in recent years; the value has gone up, but now, if interest rates and inflation rise, which they inevitably will at some point, then corporate bond holders might feel a bit left out; a bit sort of struggling, stranded on a raft. It's that high price that makes me feel a bit reluctant to recommend corporate bonds to most people.

Another issue is although I've said they're low-ish risk, there still is risk; there really still is risk. If you put money in a bank savings account and the bank goes bust, you'll be able to get money back up to a certain amount from a government scheme: the FSCS. With corporate bonds, you won't get any compensation from the FSCS.

Of course, the other point is: with shares, dividends go up. I said that corporate bonds pay a predictable income. Dividends on shares, they don't; your dividend could be cut. But if things go well and the company performs well, the dividend on a share can go up.

Right now, maybe you'd get a £30 dividend if you bought shares in Tesco, but if Tesco performs well, that dividend might rise to £35 next year, £40 the year after and so on, and actually over the term of the ten years, you might get more money from those share dividends than from the corporate bonds.

Corporate bonds are traditionally a high-yield investment at medium risk. I think they make a lot of sense for a lot of people, but right now, they just look a bit expensive. If you decide you want that predictability, how can you go and invest in corporate bonds?

Now, traditionally it's been quite hard to do so; you needed minimum investment sizes that were quite high maybe ten or even £50,000. The London Stock Exchange introduced something called the Orb' (order book for retail bonds) three years ago, and now there are more than 100 bonds on that exchange where you can invest with a minimum investment of just £1,000. If you want to find out more about that, just go to the London Stock Exchange website.

The other way to invest in corporate bonds is traditionally corporate bond unit trusts, or Oeics, where a fund manager selects corporate bonds for the funds. I'm not a big fan of these funds, because I think they don't offer the predictability that a normal corporate bond offers.

The fund manager could make the wrong choices, sell at the wrong time, buy at the wrong time, and you don't really know how your investment's going to pan out. For that reason, I'm not so keen on the corporate bond funds.

Corporate bonds have their place, and probably in a few years' time the valuation will once again look good. If you decide to invest in corporate bonds right now, good luck to you, and until next time, see you then.