Corporate bonds can play a key role in stabilising investment portfolios during periods of heightened volatility in financial markets. Not only do they exhibit lower price instability compared to equities, but as long as the issuer of the bond remains solvent, you will continue to receive fixed coupon payments until maturity.
What are corporate bonds?
When you buy a corporate bond, you are lending money to a company which means they are legally obligated to pay you.
Specifically, the company issuing the bond will usually pay you in quarterly, semi-annually, or yearly payments for a fixed period, often called the ‘term’. These periodic payments are known as ‘coupons’ and they can be paid at either a fixed or floating rate.
At the end of the term, the corporate bond reaches ‘maturity’, and the company or ‘issuer’ pays you back the ‘face value’ of the bond.
Dutch East India Company bond, dating from November 7, 1623
What is face value?
When you purchase a corporate bond directly from a company on the ‘primary market’ (the initial issuance of the bond), you will usually invest an amount equal to the ‘face value’ of the bond. Assuming you don’t sell the bond prior to maturity and the company remains solvent throughout the term of the bond, you will receive the ‘face value’ of the bond back at maturity.
Most investors however can’t access the primary market and therefore need to purchase bonds in the secondary market where prices can fluctuate in-line with supply and demand.
For example, if a bond has a $10,000 face value but is selling in the market for $9,200, it is said to be trading ‘below par’. This occurs if interest rates at the time that you purchase the bond are higher than they were when the bond was issued. If you purchased the bond at this price, you would still receive $10,000 at maturity along with the coupon payments throughout the remaining term of the bond. The coupon payments will be calculated on the face value of $10,000 (not the $9,200 that you paid for the bond). The opposite is also true where if you buy a bond that is trading ‘above par’. In this case, you may pay $10,080 for a bond with a face value of $10,000.00. You will receive only the $10,000 face value at maturity and all coupon payments throughout the remaining term of the bond will be calculated on the $10,000 face value (not the $10,080 that you paid).
How do corporate bonds differ from shares?
When an investor buys a share, they are buying ownership in a company. When an investor buys a corporate bond, they are becoming a creditor of the company.
It’s important to note however that not all bonds offer the same level of protection and in some cases, your investment could become fully unrecoverable.
What types of corporate bonds are there?
There are various types of corporate bonds which all offer different returns and protections.
If you purchase a bond with a face value of $10,000 and a fixed quarterly coupon of 10%pa, the investor will receive coupon payments totalling $1,000, paid in instalments of $250 each quarter. Another bond may be paying a fixed, semi-annual coupon of 7%pa. Investing $10,000 in this bond will return to the investor a total of $700 in coupon payments over the year, paid in two instalments of $350 each.
The different coupon levels can be explained by the different credit ratings of the issuer and by the timing of the initial issuance of the bond.
Some bonds offer fixed coupons, while other bonds offer floating rate coupons (ie coupons linked to an underlying interest rate, plus a specified percentage or margin). In both fixed rate bonds and floating rate bonds the face value of the bond will not change during the term of the bond. Other bonds, known as ‘linked bonds’ are linked to a measure of the inflation rate (such as the consumer price index (CPI)). In a linked bond, both the face value and the coupons will rise and fall with changes in the CPI.
Bonds may also be secured or unsecured. A secured bond is backed by a charge over an asset of the company issuing the bond while an unsecured bond is not backed by any security provided by the issuer.
Generally, secured bonds pay a lower coupon than unsecured bonds, because the credit risk on a secured bond is lower. However, this does not mean that an investment in a secured bond is risk-free. In the case of the liquidation of a company, the holders of secured bonds will rank with all other secured creditors of the company, while the holders of unsecured bonds will rank lower in the wind-up and will share any returns from the wind-up with all other unsecured creditors after the ATO, employees and secured creditors have been paid out in full.
Why invest into corporate bonds?
While not always the case, fixed-income assets including both government and corporate bonds, typically move inversely to equities, offering enhanced portfolio protection during weaker economic periods.
With higher interest rates now causing economic activity to weaken, many analysts are forecasting that the global economy – including the Australian economy – could falter this year or next.
Depending on the severity of any economic downturn, in such an environment, corporate bonds could provide attractive risk-adjusted stable returns, given they exhibit far less volatility than equity markets.
Disclaimer: Australian Bond Exchange Pty Ltd ACN 605 038 935 AFSL 484453 (ABE). This article is intended to provide general information of an educational nature only. It does not constitute the provision of personal advice and does not take into account your personal objectives, financial situation or needs. Before investing with ABE, you should consider the appropriateness of the investment to your particular financial and taxation situation and consider obtaining independent advice before making an investment. Examples in this article are for illustration purposes only and are not a recommendation to buy, sell or hold a particular investment. ABE makes no representation or guarantee as to the availability of a bond with the characteristics described in this article or that an investment made by you will generate the returns in the illustration. Past performance is not an indication of future performance. Investing with ABE is subject to our Client Services and Custody Agreement Terms and Conditions and Financial Services Guide.