Investing in bonds is now much easier for private investors thanks to the launch in 2010 of the London Stock Exchange's retail bond market (ORB). A by-product of the credit crunch is that cash-starved companies and yield hungry investors have helped create a new market for non-bank finance and bond issuance has picked up as smaller- and medium-sized companies diversify their funding requirements.
As with any novel investment, the need to understand the basics of what is on offer is more important than ever, particularly as corporate bonds are often confused with term-limited cash savings accounts which often go by the same name. Hopefully, this guide will give you enough tips on the basics of trading in bonds to build a durable portfolio and avoid some of the pitfalls of an asset class which hasn't featured much in the UK investment landscape for some decades.
What is a bond? Why do companies issue them?
A bond is the issued debt of a governments or companies which can be openly traded on the market. It offers a promise to pay a fixed level of annual interest via a set coupon and, if held to maturity, investors are returned 100 per cent of their capital.
Bonds are used by investors as a stable source of income and to balance off the volatility risk of shares within a portfolio. Many professional investors will do nothing other than trade bonds, with varying levels of credit quality and sensitivity to interest rates and inflation opening up interesting trading opportunities.
Companies like to issue bonds because they allow longer repayment times than are usual with bank debt. This helps with capital planning and means large amounts of money can be raised for basic funding without diluting existing shareholders. Interest (coupon) payments are also tax deductible.
Why are bonds popular?
The basic reality is corporate bonds have rapidly become an important source of income for investors who have been battered by low interest rates, with their consequent impact on cash deposit accounts and annuity rates. Bonds offer stable income and a guaranteed return of all your capital as long as the issuer remains solvent. At the same time, the stock market has proved to be a miserable store of value with share prices stuck in a decade-long trading range punctuated by a series of crashes. In such circumstances, investors cannot be blamed for finding alternatives.
The other structural factor is the credit squeeze imposed by the banks in the wake of the credit crunch is forcing smaller- and medium-sized companies to seek alternative sources of funding. The squeeze takes the form of higher arrangement fees for loans, larger charges of not using arranged banking facilities and more stringent debt covenants. The spread over gilts for bank debt has widened considerably, meaning banks are earning well in excess of their cost of funding. The other common complaint is that banks will not generally lend longer than four or five years, whereas retail bonds last two or three years longer on average.
Accessing the market has become a lot easier in the past year or so, particularly now that execution only brokers are able to source bonds as standard, although you may have to ring up and place the order. The main market-makers and order-takers are Killik & Co, Collins Stewart and Investec. Price updates are available on the London Stock Exchange's website but Investec is helping to put together a "live" index of retail bond prices which should give investors an over-view of which direction the retail market is headed.