Corporate Bonds?

janken

Have been advised by my financial advisor to put some of my ISA allowance into corporate bonds. Can anyone explain what these are. I have been told that they are one of the few funds actualy likley to rise over the next year.

dunstonh

I have been told that they are one of the few funds actualy likley to rise over the next year.

Equities are just as likely or not to rise as corp bonds. Whoever told you that is not giving you the full information or isnt very skilled in investments. Its the sort of thing you expect a bank tied agent to come out with.

As part of a balanced portfolio, then the fixed interest sector should be considered. This wouldnt just be corporate bonds but investment grade bonds, gilts, high yield bonds etc. Its not a time to be picking one fund in that sector but spreading it around the funds and making sure the assets within the fund are consistent with your risk profile and objectives.

tradetime

janken wrote: »

Have been advised by my financial advisor to put some of my ISA allowance into corporate bonds. Can anyone explain what these are. I have been told that they are one of the few funds actualy likley to rise over the next year.

Anybody advising you to put your money into a product you do not understand, and does not take the time to explain it to you isn't someone I would care to have advising me financially.

deloina

Its a debt security issued by a corporation. When you buy a bond you are in effect loaning the company money. You buy them at face value and they generally pay interest on the bond perodicially, unless its a zero coupon bond. And at maturity return the face value amount that you paid for the bond is returned to you.

Bonds may be back by nothing but the good faith of the company and their ability to earn profits. Or it may be backed by company assets. In the case of bankruptcy bondholders are paid ahead of common stockholders and preferred shareholders.

Zero coupon bonds dont pay interest. Instead they are bought at a deep discount to the face value. But if its in a taxable account you still owe taxes on the imputed interest. Its probably better to buy a bond fund than the individual bonds. :beer:

Reaper

You can think of corporate bonds as a company wanting a loan. You give them a lump sum and in return they pay you a fixed interest rate until the date comes around for them to pay you back.

Bonds can be sold on to other people for more or less than you originally paid for them. The key things that affect their price is how much interest they pay compared to general interest rates, how long until they are due to return the money, and how likely the company is to go bust and not pay out at all.

Rather than choose individual bonds you can opt to buy into a fund which does all the buying and selling decisions for you.

Because of worries about companies going bust you can currently buy bonds paying good rates of interest for not much money which makes them look tempting. If confidence returns then you can expect the bonds values to rise. However if the economy takes a further turn for the worst and more companies go bust than expected then bond prices will fall because people won't want to take the risk.

There are different types of bonds but that's probably enough detail to be getting on with.

I don't think the advice given by your advisor is necessarily wrong - it may well be an opportunity, but they certanly should have explained the product to you and you have to understand that although the possible rewards are good bonds are riskier than they have been in the past. As always better returns are associated with higher risk.

dunstonh

I don't think the advice given by your advisor is necessarily wrong - it may well be an opportunity, but they certanly should have explained the product to you and you have to understand that although the possible rewards are good bonds are riskier than they have been in the past. As always better returns are associated with higher risk.

Just to clarify, I wasnt saying it was wrong. However, the OP wrote it in a way that suggests how its being recommended is wrong. e.g. single fund, only think that is going to make money and no reference to other bonds.

thelawnet

janken wrote: »

Have been advised by my financial advisor to put some of my ISA allowance into corporate bonds. Can anyone explain what these are. I have been told that they are one of the few funds actualy likley to rise over the next year.

This book has a lot of information on bonds

http://www.amazon.co.uk/Intelligent-Investor-Benjamin-Graham/dp/0060555661

Bonds are a means for companies to borrow money. They do this by selling bonds at £1 each. A large company could raise billions of pounds in a single bond issue.

Bonds are listed on various financial sites, listed as 'Issuer Name', 'Coupon', and 'Maturity'

Here's a listing of some popular bonds:

http://www.selftrade.co.uk/market-data/gilts-bonds/bonds.php

The maturity is the date that the company pays back your £1 principal. Alternatively a bond can be 'perpetual', which is effectively like an interest-only mortgage. Such bonds are generally callable at the issuers option after a certain number of years, which means that the issuer can buy them back (above the £1 issue price). Most perpetual bonds are issued by banks to form a part of their 'Tier 1 Capital' required for them to trade. Some bonds listed there have the suffix 'MTN', which means 'Medium-term Note'. In practical terms these are the same thing, they are just marketed differently.

The coupon is the percentage interest that the bond offers agains the £1 repayable.

The catch with bonds is that the price is not fixed at £1 - in fact they can go above or below that price. Why? It reflects the trading prospects of the company and also interest rates. For instance, if base rates are 8%, in order to get people to take on the risk of lending it money, a company might be need to offer an 11% coupon on its bonds. If base rates were to subsequently fall to 5%, then 7% return might be considered sufficient reward to lend to a company. As a result, the price of the bond would rise above £1. Equally if a company borrowed money when rates were low and they subsequently rose, the resale value of the bond would fall to reflect that people would want more reward.

This fluctuation means that instead of the 'coupon', two other numbers are used to tell you the income you will earn on the bond.

These are 'Income yield' and 'Gross Redemption Yield'.

The income yield is very easy to calculate, and is simply the coupon divided by the current price.

Thus AIG 5.375 14 Oct 2016 MTNworth 69.90
has an income yield of 5.375/69.9 = 7.7%

In other words, by buying this bond you are buying an asset that has a yield of 7.7%

The yield to maturity (gross redemption yield) OTOH, is the return taking into account, not just the interest payments, but also the fact that you will get £1 back on maturity. This is the real return on your money if you intend to hold the bond to maturity.

If the bond is selling below par (below £1), the gross redemption yield will be higher than the income yield. If it is selling above par, the gross redemption yield will be lower than £1.

The way this is calculated is by discounting the value of the future cashflows (i.e. the 5.375p annual coupon payments, and the £1 principal repaid at maturity) so that they sum to 69.9p, which is the current market price.

The actual cashflows are as follows, starting from today:

DateYears elapsedCashflow03/02/20090.00-69.914/10/20090.695.37514/10/20101.695.37514/10/20112.695.37514/10/20123.705.37514/10/20134.705.37514/10/20145.705.37514/10/20156.705.37514/10/20167.70105.375

If we simply sum the undiscounted cashflows, they come to 143p, which is far more than we paid. Therefore, we need to calculate the internal rate of return, r.

The present value of a future payment of is given by Z = p * e^(-rt), where p is the future payment, e the Euler's number, and t is the elapsed time before the payment is made.

So for the first payment of 5.375p, Z = 5.375 * e^(-r*0.69).

We don't know what r is (well we do, it's listed on the bond page, but let's disregard that), but we do know that the sum of all such Zs for all future payments equals 69.9p.

So it's very easy to plug a starting number into a spreadsheet, let's say 6%, and use it as the basis for the formula above. By trial and improvement, you can find out the gross redemption yield.

Or of course you can use the yieldmat function, or look it up online.


The other main feature about bonds is that you are not guaranteed to get your money back. If the company goes bust before maturity, you will not get paid, although as a bond holder you are in a better position than a shareholder (who gets nothing), and you will often get back 20 - 30p of your bond. Thus bond prices have fallen substantially recently, because people are worried about companies going bust. Last week you could have bought Barclays perpetual bonds for just 50p, against over £1 last year. In addition, the recession means that people sell off their bonds, particularly the ones perceived as more risky, to move into cash (which is risk-free, though obviously at risk to inflation and Labour devaluing the pound).

People selling assets cause their price to fall. As a result, bonds at the moment are very cheap. How do we define cheap? If you buy 10 3-year bonds 0% at 60p each, one company goes bust, and the risk-free rate of return (what you could get with National Savings) was 1%, and nine of them are repaid, then you will get back £9. But you only paid £6, so have made a handomse profit, compared to leaving the money in the bank where you would have earned £6.18.

It is possible to calculate the implied risk of default by comparing the yield of corporate bonds of a given maturity with gilts (government bonds, considered risk-free, although this is no longer the case thanks to 12 years of Labour government). A zero coupon bond maturing in 3 years should sell for 1/1.022/1.022/1.022 = 93.7p if you compare to gilts of similar maturity (which are yielding 2.2%). If one is selling for 60p that implies that the risk of default is 36% (64% of 93.7p is 60p).

At any given time the price of a bond is always wrong. In a bull market bond prices will be too high. People will be happy to lend money to cyclical companies such as builders, which are guaranteed to run into trouble every few years when the recession hits, at little or no premium. And in a bear market bonds will be too cheap, as people start to panic and sell their bonds at any price.

It has been calculated that current bond pricing implies the highest rate of default in history - higher than even the Great Depression. This would suggest that bonds are now too cheap.

Even solid companies with steady incomes, such as tobacco, utilities, and pharmaceuticals are at similar prices to last year, despite massive falls in rates.

For instance, British American Tobacco's 12/12/2019 6.375% bond is trading at a discount. While the price is up 3.25% on 1 year ago, that ignores the fact that a yield of over 6.5% is now outstanding whereas last year you could have got that rate in a bank account (admittedly that bank would have been Icesave). Gilts with a comparable maturity are selling at a premium and yielding 3.9% (reflecting the fact that over the next 10 years, rates will not always be 1%). So you are paid a 2.6% premium to lend to BAT rather than the British government.

If you move down to less prime sectors, Dixons are trading at just 50p, giving an income yield over 12% and yield to maturity of 28%. If they make it through the recession, this would be very profitable.

Not all companies will survive, which is why people buy bond funds, to spread the default risk without having to individually buy dozens of bonds. I recently invested here:

http://www.h-l.co.uk/funds/security_details/sedol/3302888

This fund hold some less than prime bonds, and consequently prices have fallen dramatically, meaning the yield is up around 12%.

This one is far more defensive at 6.45%:

http://www.h-l.co.uk/funds/security_details/sedol/3302877

A cheaper way to invest in bonds (and shares) can be using an ETF. The expense ratio of the Ishares £ Corporate Bond fund is only 0.2%. This is 1% lower, very signifcant on such a fund, than the Invesco Corporate Bond fund, the reason being that the ETF follows a bond index, and has no discretion over which bonds to buy. This means it has lower costs, because no research need be done, but will tend not be balanced. Most investment-grade (the kind that this ETF is limited to) bonds are issued by banks, and hence this fund is 61% in banks. If banks run into trouble then your fund will suffer disproportionately badly.

That's not to say that this ETF is bad, it is not, but if you were going to invest £5,000 in fixed income, then you would want no more than £2,000 of that in that ETF because of its unbalanced nature.

Anyway, your advisor is quite right, it is a very good idea to have bonds in your ISA. Why?

The reason is that bonds, particularly now, pay higher income levels than equities, and have done so for many years now. Income is of course taxable at 20 or 40%, so by putting your money in the ISA, you are avoiding a lot of tax.

By contrast shares have much lower income levels, and the gains, while taxable, can be carefully planned so that you minimise your tax bill, and in any case you have a £20k Capital Gains Tax Allowance to use (assuming you are married) each year.

As a source of income, bonds in an ISA are now very attractive when compared against cash ISAs, and the potential tax savings are much greater.

expounder

I have three maxi isas in norwich union [now arriva] in higher income corporate bonds purchased in 2000. total inevstment £21.000. The value of these bonds have dropped by over 25% and I am at a loss what to do. Whether to withdraw all now and cut my losses, leave them in and hope they will recover within the near future.I am still receiving the original monthly figure in income even though the value has decreased.

As they have devalued so much in such a short space of time [within eight months] they could drop futher. I joined without employing a financial adviser [mistake] as I think the commission he/she would have received is being deducted anyway.

Anyone with any expertise out there with possible pointers or in the same boat.?

I am retired, and 80 years of age which could be a factor in what decision I make.

purch

As they have devalued so much in such a short space of time [within eight months] they could drop futher

They have fallen so far, because the Yields have had to adjust higher to reflect the increased risks. They will continue to fall, until they are priced to reflect these risks.

The falls you have experienced show why these Funds should not be marketed as anything other than medium risk.

If you consider that the current recession that we are in is likely to get worse, or continue longer than 12 months or so, then these Bonds are likely still overpriced, and probably will fall further.

eeja

Everything posted above is correct and valid. What is missing is the advice that one should study the covenants of each bond before buying.
Not mentioned above is the fact that some well known bonds ie Barclays Bank bonds have a clause which excuses them from paying any coupon ( interest ) where the Co has not declared a dividend on their shares .
This is NOT mentioned by way of asterisk or otherwise on the fixed income websites such as Bondscape so BUYER BEWARE . You think you are safe with your income barring insolvency but you are not. It only takes a bad trading year and you might not get a penny interest on your investment .
PS ..The above represents the theory the facts and the legal position . Does anyone however know if Barclays have in fact ever invoked this provision and defaulted this way on their bonds ?

dunstonh

eeja - the thread is about corporate bond funds. Not individual corp bonds.