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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:

With the opening of London Stock Exchange’s new retail bond market [1], 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 [2] 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 [3] are:

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 [4].

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 [5], you might instead be being offered a savings ‘bond’, a structured product [6] disguised as a bond, or some other kind of pseudo-bond. (One company even launched a shaving bond [7]!) See my post about other kinds of bonds [8] for more detail.

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

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.

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 [9].

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.

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.

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 [10] 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 [11] with corporate bonds.

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 [12].

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 [13].