A corporate bond is a debt owed by a company to an investor, a form of debt security.
The bond is an asset which can be bought and sold, on the basis that the company which issued it will repay it after a fixed period of time.
The important part of the bond, from the investor’s point of view, is that the company will pay a rate of interest on the debt during the period of the bond. But because the bond can be traded, it will also change in value over time.
The bond mechanism
Companies issue bonds because they are looking to finance some sort of project and want to access a large amount of capital to do so.
They usually set a fixed rate of interest and if that is above the headline rate of interest then it becomes an attractive investment option.
So for example, if interest rates are at 1%, then a bond that pays 3% is a good opportunity to increase returns.
But, if interest rates rise above 3% during the term of the bond then investors will want to switch out their money.
Why corporate bonds vary in their rate of return
The rate of interest a corporation pays on its bonds tends to be related to the financial health of the company.
A long-established blue chip company with healthy income streams is seen as a safe bet, so it can usually offer bonds at a lower rate.
Younger companies, or those in financial difficulties will probably have to pay a higher rate of interest to be more attractive to investors.
So an investment in a corporate bond fund that pays a higher rate of interest is usually a riskier proposition – the company might go into liquidation.
The risks of bonds
A company that goes bust may not be able to repay its debts, so a corporate bond has risk attached to it.
But as a vehicle for investing in a company it’s seen as slightly safer than a company’s shares. Creditors are paid before shareholders when a company goes bankrupt, so bondholders are more likely to get their money back.
Bonds can also change in value, just like shares.
A £1,000 bond in a company that appears to be in trouble can be traded below its face value – a great opportunity if the corporation revives its fortunes, because it will repay the full amount, but potentially worthless if the firm goes bust.
On the other hand, a bond issued by a company in rude health at a decent rate of interest might rise in value initially, particularly if bank interest rates fall. As the bond gets closer to maturity it will tend to get closer to its face value.
High-yield corporate bonds
Companies with a lower credit rating, of the sort issued by Moody’s, Fitch or Standard and Poor’s, need to pay better rates of interest than blue chip “investment grade bonds”. These are known as high-yield bonds, or junk bonds.
They may issue variable rate bonds, in the hope that as they become more successful, their credit rating will improve and they can reduce the amount of interest they pay.
Buying corporate bonds
For smaller investors, the easiest way to access corporate bonds is via an investment fund, run by a manager.
Rates of return can be as high as 8% – but remember that if the corporate borrowers default, your money might be at risk.