The main types of corporate bonds

Time for another entry in my corporate bond series, which is taking rather longer than expected to finish. (We need to hurry along to see whether corporate bonds are worth an investment at depressed levels before they’re no longer depressed!)

Note that while I don’t claim to have the last word on shares either, I’ve spent much more of my time studying and investing in shares compared to bonds. As I’ve as I previously explained, I don’t think corporate bonds are attractive usually, so I’ve directed my efforts on shares.

But don’t click away just yet! The reality is most private investors shouldn’t even try to become expert on obscure corners of the bond universe.

I believe we should only be considering the simplest corporate bond investments:

• Investment or high grade corporate bonds
• Funds of investment grade corporate bonds
• High-yield corporate bond funds

Even these aren’t must-haves; generally I believe government bonds are a better investment for private investors than corporate bonds (but note that government bonds such as US treasuries and UK gilts were expensive last I looked).

In this post I’ll explain the most important types of corporate bonds for private investors. In the next part of the series we’ll look at convertible bonds, and then we’ll briefly cover some other kinds of bonds you might hear about, but that generally I wouldn’t invest in.

To repeat myself, 99% of private investors thinking about corporate bonds should look no further than the domestic investment grade bonds detailed below, or perhaps in certain circumstances a high-yield bond fund.

Investment grade corporate bonds

Investment grade corporate bonds (also known as high grade corporate bonds) are the best-quality corporate bonds, as determined by rating agencies such as Moody’s. They are debt securities, issued and redeemed by the strongest companies.

Technically, a bond is considered investment grade if its credit rating is judged as BBB- or higher by Standard & Poor’s or Baa3 or higher by Moody’s.

Corporate bonds are issued in blocks of say £1,000 in par value (or $1,000, or whatever your currency is). You buy them either at issue or on the stock market.

Provided all goes well with the issuing company, you get a regular interest payment up until a pre-determined date when the bond is redeemed, whereupon the nominal value of the bond is returned to you and the bond ceases trading.

Your total return is determined by the price you paid, and the bond’s interest rate. (See my earlier articles for an explanation of these corporate bond essentials and to learn how bond prices fluctuate).

Just to keep things complicated, some corporate bonds are ‘callable’, which means companies can redeem them early if interest rates become unfavorable. We’ll see later in the series that callability is bad from our point of view.

Corporate bonds are more secure than shares

A company must pay the interest due on bonds whether or not it makes a profit. This is in contrast to dividends, which are paid at the directors’ discretion.

Corporate bond holders also rank ahead of equities in the company’s capital structure.

This means corporate bonds are less risky than the shares of the same company. This is especially true if you buy the corporate bonds when they are first issued and hold until they are redeemed. (Between those two points the bond price fluctuates, which could mean a better or worse return for you).

In return for this lower risk, the return is lower than for shares; the fixed interest rate payable by normal corporate bonds does not change over time, unlike share dividends which generally go up.

Note that although investment grade bonds are the safest corporate bonds, they can and do default, since even well-known companies can go bust. They are therefore far riskier than government bonds, which in the UK and US have never defaulted.

In normal times, the extra interest paid for this extra risk over government bonds is between 0.5-1%, which I think is too low to make them attractive investments.

By the way, when I say ‘domestic’ investment grade corporate bonds, I mean bonds that are issued by companies operating in your own country and currency.

You can buy overseas corporate bonds if you want, but then you’re very exposed to short-term currency risk, too.

High-yield or junk bonds

These are corporate bonds deemed by the ratings agencies to be below investment grade. They may have been issued by weaker companies, or they may be the bonds of formerly strong companies that have fallen on hard times.

As the name ‘high-yield’ suggests, the interest rate on high-yield bonds is much higher than on investment grade corporate bonds or government bonds. This is to make up for the far greater risk; high-yield bonds frequently default.

Generally, high-yield bonds are bought by investors speculating that the bonds will be favorably re-rated and so will rise in price.

It is sometimes fashionable (invariably after good spell of performance) to suggest high-yield bonds aren’t that risky as long as you hold a basket of them. But a bad patch will soon see them labeled by the charming term ‘junk’ once more.

Clearly the time to buy junk bonds is when their yields are extraordinarily high versus investment grade corporate and government bonds. Unfortunately, those times tend to be when people least feel like investing in them, due to the turbulent conditions.

Due to the fear in the markets, 2009 may well prove retrospectively to be just such a time. On the other hand, in a severe recession companies will go bust in droves. Capital losses from defaulting bonds could then overwhelm the extra interest you get on your junk bond fund, leading to a bad investment result.

But even high grade corporate bonds can and do default (or get downgraded), so as ever it’s all about the price you pay and the potential return.

We’ll be looking at this risk/return potential for corporate bonds later in the series, so do subscribe to stay up-to-date.

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What causes corporate bond prices to fluctuate?Convertible bonds