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Understand Corporate Bonds.

An alternative to equities?

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The British Government raises money through taxes and by borrowing money. One of the ways it borrows money is through government bonds, which are simply loans to the government, often for a set period and for a fixed interest rate. At the end of the period, the redemption date, the loan is repaid to the lender but up until then can be bought and sold on the open market. Government bonds are often called "gilt-edged securities" or "gilts" for short and are perceived as one of the safest forms of investment, given the high creditworthiness of the government.

Individual companies also raise money in several ways. Two important ways are through issuing ordinary shares and by issuing "corporate bonds". Corporate bonds are loans to companies, again for a fixed period, and at a fixed rate of interest, called the coupon. Interest is paid once a year or more regularly.

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What are they?

Corporate bonds have advantages over ordinary shares:

  • Income and capital payments must be paid in full to bondholders before shareholders get their dividends and if a company is wound up, the bondholders are paid before the shareholders.
  • Bonds usually pay a higher interest rate compared with share dividends.
  • Bonds are more tax-efficient than ordinary shares when investing in ISAs. The government intends to withdraw the 10% tax credit on share dividends on 5th April 2004, however it has no plans to remove the 20% tax credit on interest received from bonds.

The main advantage that shares have over corporate bonds is their share price tends to rise over time, giving capital growth.

Corporate bonds aren't perceived as being as safe as government bonds, so they pay higher rates of interest. All bonds issued by governments and companies are given a risk rating, which is discussed later. The market for bonds is now well established, with about £210 billion in gilts and £230 billion in corporate bonds issued.

Between the issuing date and the redemption date of a bond, it may be traded on the open market. The price will depend on the interest rates at that time and the perceived creditworthiness of the issung company. The bond market is very busy and is very liquid with buyers and sellers of a particular bond readily available.

Two important definitions:

  • "Running Yield" (also called the "distribution yield" or income yield") is the interest rate on the bond as a percentage of the price the holder of the bond paid for it. Many bonds have fixed interest rates, so when it is traded the buyer may get a "running yield" which might be higher or lower than the coupon, depending on the purchase price.
  • "Redemption Yield" is the return expected if the bond is held until the redemption date. The "redemption yield" allows for all the cashflows of the bond, including coupon payments, the current price and the value at the redemption date.

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Bond Grading.

The interest rate that an issuing company has to pay increases to offset the increased perceived risk of the issuing company. There are several rating companies that assess and grade these risks. Standard & Poor's and Moody's are large agencies who classify bonds, although they use slightly different grading symbols. AAA or Aaa are the highest quality, while D is the lowest. Higher quality bonds are also referred to as "investment grade", while high-yield (high risk) bonds are often called "non-investment grade".

Investment grade bonds will generally move in line with government gilts, given their higher security, whereas high-yield bonds will be more unstable, being affected more easily by personnel changes and contract wins.

The Credit Rating System

Moody's Rating:S & P's Rating:Typical Yields:Grade:
Aaa AAA UK Govt. 5.0% Investment Grade
Aa AA Govt of Portugal 5.6% Investment Grade
Baa BBB ICI 7.1% Investment Grade
Ba BB BSkyB 7.1% High Yield Bonds
B B William Hill 8.8% High Yield Bonds
Caa CCC TM Group 11.1% High Yield Bonds
Ca CC High Yield Bonds
C C High Yield Bonds
D D High Yield Bonds

Note: Source: Bloomberg, 01.03.02.

Investment grade bonds are deemed to be safe throughout their life until their redemption date. High yield bonds have different degrees of risk and need to be carefully chosen and consistently monitored. Bonds may be upgraded or downgraded during their lifetime. This will affect their capital and yield values.

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Are corporate bonds suitable for you?

Your attitude to risk will dictate whether investment grade bonds or non-investment grade bonds or a mixture is right for you. Your own personal circumstances and statistics should also determine the suitability of corporate bonds. All bonds carry an inherent risk to the money you invest, whether it's "safe" gilts or grade D corporate bonds.

If you are 16 or over, and live in the UK, you can invest up to £7,000 in an ISA every tax year (see How to Understand ISAs). Using an ISA "wrapper", you can invest in a corporate bond fund and not pay tax on any gains that you make.

Choose between income or growth. Your own personal circumstances will affect the suitability of having investments that generate a regular income or simply increase in value. Corporate bonds can provide a steady income and the investor should consider the income that they need now and over the term of the investment. In selecting the right funds or bonds, you should be well aware of the extra risk that higher yield bonds carry. Many corporate bond funds pay income every three months, however, special arrangements can be made for monthly payments. Also, income can be reinvested until it is needed.

Investing in corporate bonds through a fund manager can have advantages:

  • The expertise of the fund manager can be harnessed to research and monitor the bonds and the market in a way that many individuals can't or don't want to attempt to compete with. Most corporate bond teams will meet the managers of individual companies to understand the nature of their business before investing in their bonds.
  • Many funds will invest in 20 or more corporate bonds, thereby diversifying the fund and reducing the impact should a company default on its bond.
  • The pooled investments of many individuals will save costs. Funds of this nature also incur charges, however, so make sure that you are well aware of the entry, annual, and exit charges on any investment and its intended term.

If you have any doubts or questions, you should speak to an Independent Financial Adviser before you invest.

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