We've been through - or are still in, depending on your viewpoint - the worst recession since the 1930s. Companies have been cutting jobs, slashing profit forecasts and trimming dividends. Thousands of firms have collapsed into bankruptcy or administration. Yet, strange though it may seem amongst this corporate carnage, investors have been falling over themselves to lend money to companies. That, in effect is what you are doing when you buy corporate bonds. The truth is that for thousands of investors - who have made corporate bonds one of the best selling asset classes this year - the increased risk of default is definitely worthwhile.
The natural home for private investors seeking corporate bonds have been funds, and this is reflected in recent figures from the Investment Management Association which show March's net inflow into sterling corporate bond funds was £1.45bn (see ). However, for the investor prepared to delve a little more deeply into the investing undergrowth, there are some very interesting opportunities to buy individual bonds. The attractions are that you can pick exactly the yield you would like to get, choose issuers with which you are comfortable, and have the satisfaction of an extra level of safety above all those who are relying on the dividends from ordinary shares. Those with Isas can hold bonds with more than five years to maturity at the time of purchase. Any corporate bond that is listed on a recognised exchange can be held within a Sipp.
Easier said than done
However, in my own attempts to buy corporate bonds, it became clear that there are some hefty obstacles for all but the most self-confident investor. The market place is opaque, there are no real-time prices for those who don't have access to professional dealing systems, and online prices are only available for a small selection of 200 or so corporate bonds. And these are a day old. Most retail stockbrokers, even those execution-only online firms, will buy corporate bonds for you. But the chances are that they won't have much expertise, that they won't carry a list of bonds that they can trade, nor have any additional information on those bonds. You will have to deal by telephone, you will need helpful brokers who are prepared to spend a bit of time working the phones to market makers, and because of very wide spreads you may well be frustrated in your attempts to snare the best yields.
A word of warning here: most websites use the mid-price for the running yield, a polite fiction given the huge spread on the most interesting and high-yielding bonds. A couple of years ago, a typical bid-offer spread would be around 1 per cent of the price. Now it can be 5 and in some cases 15 per cent of the face value. For accurate running yields, you must use the offer price, which may make the bond much less attractive. Clearly, if you are not getting the deal you hoped, then you should hold off. There will always be another bond, another day and another price. It's a huge market out there and no one person can explore it in full.
That isn't the end of the difficulties. Building a balanced portfolio of corporate bonds requires a very significant investment. Many bonds are only traded by market makers in minimum lots of £5,000 or £10,000 nominal. Some of the most attractive and liquid bonds are, for European compliance reasons, offered only in lots of £50,000, putting them beyond the reach of all but the wealthiest private investors. There are in any case only two to three market makers for most issues, and in the case of the more obscure bonds, just one. For most investors looking for a reasonable uplift to returns but the greatest safety and clarity, the plain vanilla bonds listed on Bondscape, and the Investors Chronicle's own website (data here comes from Bondscape) are going to offer enough of a choice. There are rock-solid issuers like the World Bank and the European Investment Bank, right through to troubled companies like Enterprise Inns, whose shares may be too racy for all but the most adventurous investor, but whose bonds may add just enough safety to be worth a closer look.
Corporate bond basics
Like any bonds, corporate bonds have an inverse relationship between yield and price. As prices go up, yields fall, and vice versa. All bonds are affected by interest rates. Unlike government bonds, in which the safety of the borrower is pretty much assured, the value of corporate bonds hinge on the perceived creditworthiness of the issuer. So a heavily indebted builder, such as Taylor Wimpey, has bonds which have traded at less than three quarters of their face value. Others, like Bradford & Bingley, have been even cheaper. The first stop for assessing the quality of bonds are the rating agencies, such as Standard & Poor's and Moody's, who assign credit ratings. These vary from AAA, for the very best borrowers, down to BBB minus for bunds that are considered 'junk' and not of investment grade (see for more on ratings). However, there is plenty of money to be made in junk, for those who know what they are doing.
To stand a chance of investing in corporate bonds, you have to get your head around the yield mathematics. It isn't always straightforward. When a bond is issued it will have a coupon which is what is paid per £100 worth of stock. If a bond is trading at the price of issue that is said to be par. Howevery the yield, or more precisely the running yield, is based on the price in the market. So if a 5 per cent coupon bond was trading at 75 per £100 nominal, the actual yield would be 6.66 per cent. To turn the coupon into the running yield you simply multiply it by 100 and divide by the market price. Yields to maturity are more complex, and take account of the discount (or premium) to par in the price too, with that built in capital gain (or loss) spread over the term to redemption. Once you have bought your bond, you will have an additional cost on top of commission and (if relevant stamp duty) which is the accrued interest. This is the proportion of the coupon you have to pay the seller to reflect the holding period he has had before the payment date. So if a bond coupon is paid on 16 August and you bought six months earlier on 16 February 16, then you have to cover half the annual payment. The figure is worked out by the market maker and will appear on your trade confirmation.
Researching bonds
Getting information on the full range of corporate bonds isn't easy. That perhaps isn't surprising given that there are many thousands listed. The best advice for investors new to the area is not to stray too far from plain vanilla investment grade bonds whose prices can be easily obtained and which have a reasonable bid-offer spread. New issues, which are liquid and where the prospectuses are easier to find, are also a good way in. The IC's website has a range of day-old prices which give issuer, running yield, price and maturity details (see www.investorschronicle.co.uk/bonds). You can sort by yield, coupon or expiry, making it very easy to find the type of issue you want. Bondscape additionally offers bid-offer spreads, yield to maturity and EPIC codes (otherwise it can be easy to mistake two similar issues). Prices are still a day old, though. It is particularly hard to get information on some of the more complex bonds, which carry various kinds of subordination, and perhaps are some way towards being equity.
Before even considering such bonds, it is wise to research them in as much detail as possible. The best starting point is the investor relations section of the issuer's website. Once you know the year of issue you should be able to download a copy of that year's annual report which will detail the issue and what its purpose was. You can save time by using the search facility on the PDF document to home in quickly on the relevant section. You may also be able to find an electronic copy of the prospectus, which apart from the pages of lawyers' verbiage, will give you some clear ideas of where the issue stands in seniority and under what circumstances it may be converted to another type of bond or when a payment may be missed.
Most bonds cannot be defaulted on while ordinary and preference dividends are being paid. Some bonds are termed subordinated, which means they are inferior in rank to normal debt and are only repaid from a firm's liquidated assets after normal bondholders are repaid in full. Such bonds can usually be spotted by their higher yield than other issues in the same company and the extensive list of sub-clauses and options the company reserves for itself. Suspicions of the debt being subordinated (sometimes called junior) can be cross-checked by searching for their credit rating. Even if the worst happens, and your bond ends up being defaulted, the average recovery historically is around 70 per cent. You may also find that you are offered equity in lieu of your bond. Given that this will occur only after existing equity holders have been diluted out of existence, this may turn out to be a reasonable recompense.
Default risks
At a time when base rates are 0.5 per cent, savings accounts are miserable and inflation has, for now, died off, the attraction of corporate bonds lies in their yield. But how safe are they? Certainly, with a solid retailer like Marks & Spencer, the chance of default looks very small indeed. However, the prices of corporate bonds at their lows were predicting a level of corporate default that was far worse than the Great Depression of the 1930s. Though ratings agancy Moody's said defaults in the year to March were 7 per cent, they could reach 15 per cent in 2009, with 19 per cent in Europe. Nevertheless, bond prices were for a while predicting even worse, perhaps as much as a 40 per cent wipe out over the next five years, according to M&G's head of retail fixed income Jim Leaviss.
Mark Glowrey, author of Investor's Chronicle's Bond of the Week column, agrees that the market, traumatised by uncertainty, has been mis-pricing risk. "The corporate bond market has been rallying since November, so investors are clearly not believing the worst-case scenarios. Defaults on run of the mill bonds are in absolute terms pretty rare. They do tend to be distorted by defaults on larger issuance of junk bonds made during the good times," he added. Indeed, the rolling average for defaults for BBB-rated bonds, the lowest investment grade issues, was only three per cent from 1920 to 2007.
