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Is it safe to invest in corporate bonds?

A lot of people arrive at this site after asking Google: Is it safe to invest in corporate bonds?

It’s a reasonable question, yet the answer is complicated.

Many people are confused about what a ‘bond’ is, with good reason given how freely the financial services industry throws the word about.

Even with true corporate bonds, safe investing will depend on:

  • The type of corporate bond you invest in
  • The performance of the company that issued the bond
  • Interest rates and inflation
  • Whether you invest in individual bonds or via a fund
  • The timing of your investment, and the price you pay

With the opening of London Stock Exchange’s new retail bond market, more people will be asking whether it’s safe to invest in corporate bonds.

In this article I’ll answer as simply as I can, but please do read the rest of my corporate bond series for more.

1: The type of bond you invest in

Make sure you’re talking about true corporate bonds, which are a distinct investment class focused on loans issued by companies, which you buy and are paid interest on.

The main types of corporate bond investment are:

  • Investment or high grade corporate bonds
  • High-yield (aka junk) bonds
  • Funds of investment grade corporate bonds
  • Funds of high-yield corporate bonds

Investment grade corporate bonds pay you less income but are safer than high-yield bonds – the latter are from companies more at risk of defaulting.

Bonds that AREN’T corporate bonds

If you’ve seen an advert for a bond or a fund with ‘bond’ in its name, or have been suggested something by a financial adviser, you might instead be being offered a savings ‘bond’, a structured product disguised as a bond, or some other kind of pseudo-bond. (One company even launched a shaving bond!) See my post about other kinds of bonds for more detail.

These other types of bond all have very different risks and rewards to true corporate bonds:

  • A savings bond from a High Street bank is much safer – it’s a fixed-interest savings account, covered by the FSA’s £50,000 guarantee.
  • A guaranteed equity bond (GEB) may be more or less safe (but it will certainly be more confusing!)

2: Corporate bonds and companies

Since corporate bonds are issued by companies, how safe a particular bond is depends on how secure that company is.

For example, suppose you buy a bond issued by Vodafone that pays you 6% a year, and that matures in 2020. The safety of this bond depends on Vodafone being able to meet its debt obligations from now until 2020, which in turn depends on how its business performs.

  • Vodafone will need to have sufficient money to pay you and the other bond holders interest, and to repay your capital in 2020 (or be able to borrow more).

If Vodafone gets into trouble, it may skip its bond’s interest payments – known as defaulting – which will massively reduce the value of your bond holding, as well as lose you income.

Default is unlikely with an investment grade bond from a company like Vodafone, but it’s possible.

3. Interest rates and inflation

If you hold your bond until redemption you will get all your money back (defaults aside), but in-between bond prices fluctuate.

This fluctuation makes bonds much less safe than a cash deposit – at any point in time your bonds may be worth more or less than you paid for them.

The main factors that cause bond prices to change are expectations about interest rates and inflation.

  • If people expect interest rates and/or inflation to rise, they will pay less for the fixed income from a bond, causing its price to drop.
  • If people expect rates/inflation to fall, bond prices will rise.

You see then that one answer to “Is it safe to buy corporate bonds?” is another question: “Do you expect interest rates or inflation to rise?

4: Individual bonds versus a bond fund

If you buy an individual corporate bond, you’re at risk of losing everything if the company behind it goes bust.

For this reason, buying the bonds of one company can’t be considered safe.

You can massively reduce this problem by buying many different bonds at once, most simply by investing in a fund or investment trust that specialises in corporate bonds, or by putting money into passive tracker such as the iShares corporate bond ETF.

Investing in a fund is much safer than buying individual bonds, but it comes at the cost of annual charges and the risk your manager is a rubbish bond trader.

5: Timing and valuation

Like all investments, the performance of your corporate bonds depends on the price you pay.

  • You’ll never lose all your money investing in a corporate bond fund, but you could easily see the value plummet if inflation takes off.
  • If you invest in corporate bonds when yields are high and people expect more inflation but inflation unexpectedly drops, the value of your bonds could soar.

Safety when investing in bonds therefore depends upon getting into the bond at a fair price, compared to the risks.

A special circumstance is recession, when people fear more bonds will default.

At the end of 2008, for instance, people were so terrified of a Depression that corporate bonds were very cheap compared to government bonds – and also compared to the historical record. People who bravely bought bonds then enjoyed bigger and faster gains than you’d normally expect from bonds.

This brings up the issue of risk and reward with corporate bonds.

  • Your investment in bonds is much ‘safer’ than equities, which will fluctuate a lot more, and individual bondholders rank ahead of shareholders if a company goes bankrupt. But as a result the long-term returns will likely be lower.
  • You’ll get a higher yield buying a corporate bond than with a government bonds, since the extra protection offered by government bond makes them more expensive. Here you’re getting higher rewards, but you’re taking on more risk.

Most experts suggest you add corporate bonds to your portfolio to reduce volatility and boost income, as shown by my listing of example ETF portfolios.

Personally, I think that when corporate bonds are going to do well, shares will usually do a lot better. I therefore prefer to buy more shares, although if I was an older investor I’d probably buy some corporate bonds.

Government bonds are a different matter. They are massively more secure (‘safer’) than corporate bonds or shares, and I would certainly buy government bonds at the right price.

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{ 4 comments… add one }
  • 1 Daddy Paul February 4, 2010, 8:38 pm

    I think we are in a good time for high yield bond funds. Most of the damage has been done and companies who are going to fail for the most part have. I would never hold a single corp bond I would let a fund manager figure that out.
    .-= Daddy Paul on: Choosing the best mutual funds =-.

  • 2 The Investor February 4, 2010, 9:52 pm

    Yes, I agree they’re probably most attractive bonds at the moment, but if I’m buying risk I’m just a fool for equities, as they say down south. Agreed about a bond fund, you’d have to be mad to buy even a dozen high yielders and think you were diversified. They *do* blow up readers. 🙂

  • 3 Bret @ Hope to Prosper February 5, 2010, 7:53 am

    I’m no expert in fixed-income securities, but I don’t think bonds are a very good investment right now.

    With interest rates at close to zero, they only have one way to go and that is up. And, as you pointed out, this will cause most bonds to loose market value. If they are held to maturity to avoid this loss, the interest yield will lag the market rate for many years to come.

    The yields on muni’s and treasuries are so low, they are probably lower than inflation. (I’m talking about the real rate of inflation and not the bogus core rate posted by the Fed.) So, that’s a guaranteed money loser, with a lot of municipalities in danger of a default.

    IMHO, none of this makes bonds look very attractive.
    .-= Bret @ Hope to Prosper on: Investing in a Shaky Market =-.

  • 4 The Investor February 5, 2010, 9:47 am

    @Bret – Thanks for your extensive comment, I quite agree with everything you’ve written. In my comment to DaddyPaul I meant if I had to buy bonds at present I’d buy high yield. I wouldn’t even buy government bonds right now, and they are by far my preferred addition to portfolios for diversification.

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