Corporate bond and corporate bond funds are rising in popularity as a result of many of the funds that focus on them doing better than expected in recent years as the asset class has benefited from the low interest rate environment. But as an asset class, bonds tend to receive a lot less attention and media coverage than equities and equity-centric funds.
That’s because they are simpler and less ‘exciting’ than equities. Unless something goes badly wrong and a bond issuer defaults, there’s basically less to talk about. The investor buys the bond, receives the fixed interest that comes with the bond and then has their initial capital repaid when the bond matures. That, under normal circumstances, doesn’t leave a lot to report on. There’s little in the way of ‘narrative’ or ‘news’ around bonds for the media to cover.
But an unfortunate side-effect is that many investors probably know less about bonds than they should and often under-utilise them as an allocation within their investment portfolio.
Most investors with a reasonable grasp of the basics will at least be aware of the concept that a well-balanced and diversified portfolio should include both equities (shares) and bonds. All things being equal, the underlying logic is that equities make the biggest contribution to returns while bonds, otherwise referred to as ‘fixed income’ investments help provide stability.
That’s because equities tend to gain in capital value and pay better dividends when markets are going up. When markets correct or have a crash, however, equities can plummet in value, taking an investment portfolio’s paper worth with it. Historically, within a few years equities markets, as a whole, recover and well-diversified equities-based portfolios with them. Following downturns, stock markets, again historically, usually moved on to greater heights, taking equities-focused investment portfolios with them.
The Value of Bonds In Reducing Investment Portfolio Volatility
But the problem for investors lies in both the intervening period while they wait and hope for the value of their equities investments to recover from a stock market downturn and in the long term impact that volatility has on overall returns. If an investor has to cash in investments while stock markets are going through a rough patch, they are forced to crystalise losses before a recovery has time to take hold. And numerous studies have shown that even if losses are recovered and values of shares go on to greater heights than pre-downturn, reducing that volatility leads to better long term returns.
That’s the result of the power of compounding returns and is relatively simple mathematics.
Portfolio A B C
Year 1 +5% +15% +30%
Year 2 +5% – 5% – 20%
Year 3 +5% +15% +30%
Year 4 +5% – 5% -20%
Year 5 +5% +15% +30%
Year 6 +5% – 5% -20%
Average +5% +5% +5%
Starting Value £100,00 £100,000 £100,000
Final Value £134,010 £130,396 £112,486
In the example above, Portfolios A, B and C have an average return of 5% over the same 6-year period. But Portfolio B experiences 10% more volatility each year than portfolio A across both up and down years and Portfolio C experiences 25% more volatility than Portfolio A. After a downturn, positive returns are made on a base of less capital so it makes it more difficult to make losses up even when markets turn positive again.
So reducing your portfolio’s volatility will, all else being equal, lead to better long term returns. Which is where bonds come in. Because bonds pay a fixed yield, unless the issuer defaults, they represent no volatility. Which is why a portfolio allocation to bonds reduces overall volatility, which would be expected to lead to better long term returns.
Government Bond and Corporate Bond Returns
But if bonds offer lower average returns than equities, won’t that negate the advantages of lower volatility? Yes, to an extent. If the average return of Portfolio A is reduced to 4% and the volatility level remains stable, based on compounded returns being paid each quarter the final value after Year 6 would be £126,973.46. That’s lower than Portfolio B but still a lot higher than Portfolio C.
Government bonds, which are called Gilts in the UK and Treasuries in the USA, typically offer low yields of between 1% and 3%. That’s significantly less than the average 6.4% return, based on compounding returns, that the FTSE 100 has delivered over the past 25 years. Lower levels of volatility are not enough to make up such a huge gap.
But corporate bonds usually offer higher yields than the debt issued by economically and politically stable governments like the UK and USA. Investors put money into low yield government bonds as a slightly better alternative to holding cash. It’s a defensive investment designed to preserve capital and not one expected to earn the investor returns.
Companies, even big blue chips, are considered by ratings agencies such as Moody’s, Standard & Poor’s and Fitch as less secure debtors than stable countries like the USA or UK that have never not paid their debts. As such, companies that issue corporate bonds to raise capital have to offer investors higher yields than countries do to convince them. Ratings agencies assign companies with a credit rating. As a general rule, the higher their credit rating, the lower the yield offered.
While bonds are considered a safer investment than equities, that really only counts for corporate bonds with a high investment grade. It’s perfectly possible to invest in bonds that are at least as risky as equities. The difference is that with bonds it’s a zero sum game. In most cases the bond’s yield and principal will be paid at the agreed rate. If not, the issuer has failed and the best the investor might hope for is that some percentage of the principal is subsequently recovered by administrators. However, most corporate bonds are not secured against collateral which means if the issuer does go into administration the chances of investors recovering much of their principal is low.
How Risky Are Corporate Bonds?
S&P’s data shows that over the last 32 years, the default rate for investment grade bonds has been a very low 0.1% per year. For high yield bonds, those issued by companies with a credit rating below BBB, it is 4.22%. However, for the lowest rated issuers, those with a CCC/C rating, the default rate leaps to 26.85%.
But it’s certainly possible to invest in bonds that offer relatively high returns and still command a relatively secure rating. For example, the Bankers Investment Trust plc. 8% debenture stock 2023 offers a fixed income yield of 8% and commands a 4 star Morningstar rating.
Investing in bonds with yields between 5% and 8% and filtering out issuers with lower credit ratings needn’t be riskier than investing in equities. Rather, if capital is spread over a diversified selection of bonds, in the same way as a diversified equities portfolio is built to hedge against risk, it should be less risky.
The downside is that corporate bonds listed on the London Stock Exchange’s retail bond trading platform often require a minimum investment of £1000. However, this can be as low as £100. But the upshot is diversifying risk across enough bonds to hedge against the occasional default requires a larger lump sum of capital than is needed to drip feed into an equities portfolio.
How To Invest In Corporate Bonds?
Just like equities, corporate bonds can be invested in individually or through bond funds that offer built-in diversity across a wide selection of bonds.
Most of the bigger online investment platforms like Hargreaves Lansdown, The Share Centre or AJ Bell offer bonds as well as bond funds. You can invest in bonds either when they are issued or on the secondary market. However, if you buy corporate bonds on the secondary market, their principal value, and so the yield against what you pay for the bond, may differ from its original issue price.
If a particular bond is in demand and originally sold for £1000 at 10% yield, you may have to pay £1050 or £1100 for it on the secondary market. Because the yield stays fixed, this mean you only actually get an approximate 9.5% or 9% return at a purchase price of £1050 or £1100. When the bond’s maturity date is reached you will also only receive back the original face value of £1000 so will take the difference as a loss. That has to be calculated into the investment case.