What you need to know about the advantages and disadvantages of corporate bonds
The past five or six years has seen the rise of corporate bonds open to private individual investors. Generally offering fixed returns up to the high single digits, over a period of extremely low interest rates, cash that would often previously have been put into high interest savings accounts has been instead attracted to bonds.
Investment not savings
However, bonds are an investment and as such carry a varying degree of risk. With a savings account the only risk borne by the holder of the account is the possibility of the collapse of the bank the account is held with. Given the relative rarity of banks suffering insolvency, a risk further reduced by tightened capital requirements following the banking sector crisis of 07/08, savers generally accept this risk as minimal. Government backing of banks in trouble as well as state guarantees usually protecting savings up to a certain level even in the case of the bank’s insolvency, further strengthens this security. However, this level of security comes at the price of low returns with interest rates of more than 3% almost non-existent. Savings accounts can be considered wealth preservation vehicles, with the best case scenario in recent years the interest received keeping the holder fractionally ahead of inflation.
As a result, individuals who want their cash to work for them, increasing their net worth rather than simply preserving it, must take on some degree of risk and opt for investments. Traditionally, equities and equity-based funds, have been the dominant investment instrument of retail investors. While this is still very much the case, the bond market is growing quickly with evidence suggesting that this trend will continue.
Corporate bonds, like every investment vehicle, have advantages and disadvantage that private investors should be aware of when making their investment decisions. While there are different kinds of bonds available to private individuals we will deal here with fixed-term, non-listed corporate bonds.
Non-listed corporate bonds
- High yields – non-listed corporate bonds offer returns on capital invested which usually range from 6%-9%. This comfortably beats almost any form of fund or diversified portfolio of equities.
- Fixed interest – investors are generally offered a fixed annual interest rate with this kind of bond. This makes it easy to calculate the total return of the investment over its lifetime, with returns secured if the bond issuer does not default.
- Regular income – annual interest can be payable quarterly, bi-annually or annually, though quarterly is most common. This means that the bond holder can rely on a regular income from their investment.
- Ratings guide – while not always the case, many corporate bonds possess a rating by an accredited ratings agency. This rating assesses the risk of the bond issuer defaulting and is provided by an independent third party and helps investors make an informed risk assessment.
- Potential default – the primary risk associated with investment in non-listed corporate bonds is the potential failure of the issuer. Cash flow issues may also lead to delay or non-payment of interest instalments or the inability of the issuer to buy back the bonds at the point of maturity. While the bonds will be secured against the company’s assets there is no guarantee that their value on liquidation will cover all of the company’s debts.
- Illiquidity – non-listed corporate bonds should be considered a medium to long-term investment. Investors should accept that their capital is tied up and cannot be accessed until the bond’s maturity date. Many bonds do offer early-exit options but in the majority of cases at least part of the term must pass before this option may be activated. There are usually particular times when early exit can be requested, often once a year, and there will likely be penalties applied to the original capital invested if a bond is redeemed early in its term.
- No capital gains – unlike in the case of equities the underlying value of non-listed bonds cannot increase no matter how successful the issuer is over the period of their lifetime. At the bond’s expiry the original capital invested is returned with gains coming exclusively from interest paid.