Corporate Bonds — What Are The Risks?

We will take you through all the essential information about corporate bonds.

Updated: March 25, 2024
Matt Crabtree

Written By

Matt Crabtree

 
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The corporate bond market is the second-largest segment within the global bond market and is a popular choice for investors who are seeking fixed-income securities, due to their appealing stability, and a wide variety of credit quality, yields, and maturities available.

Like most investment vehicles, corporate bonds present a range of unique advantages and risks. Before diving into buying any kind of bond, you must understand how certain factors will affect you.

The world of finance tends to be overcomplicated and tricky to grasp. At CompareBanks, we believe that banking and investing should be straightforward and headache-free. That is why we have thoughtfully created this jam-packed article, to help you understand corporate bonds as seamlessly as possible.

We will take you through all the essential information about corporate bonds, including:

  • What Are Corporate bonds?
  • How Do Corporate Bonds Work?
  • Why Companies Sell Corporate Bonds?
  • The Risks & Advantages of Corporate Bonds
  • The Difference between Corporate Bonds & Government Bonds

What Are Corporate Bonds & How Do They Work?

Corporate bonds are debt investment grade bonds, involving a loan from an investor to a company.

When you purchase this kind of bond, you are ultimately lending money to the company you are purchasing from. The company will then use this money to either grow their business by making new investments or to pay for expenses.

Bonds differ from equities because purchasing a bond does not mean you have an ownership interest in the company you buy from. What it does mean, however, is that you are effectively “lending” money to the company, which will then be given back to you, essentially making this type of investment a debt obligation.

As the investor, the company will pay interest over an agreed period of time (until the bond matures) so that you receive more than you invested. These interest payments can either be set at a fixed interest rate, or at a variable interest rate (meaning interest rates rise or fall).

Bond Maturity & Interest Rates

The term of a bond's maturity can last anywhere between a couple of months to several years. Typically speaking, the longer the maturity of a bond the higher the risk that interest will change, impacting the value of the bond. However, longer bond maturity does not always end with a negative result. In many cases, longer-term bonds pay higher interest rates to the investor.

Short-term bonds pay usually lower interest rates but are more flexible as they are paid back faster, enabling you to reinvest your returns into a higher and newer rate of return.

When looking at the maturity of different bonds, you will often come across the following 3 maturity terms:

  1. Short-term Bonds: No longer than 5 years
  2. Medium-term Bonds: Maturity can range anywhere between 5 and 12 years
  3. Long-term Bonds: Maturity can last 12+ years

Does Term To Maturity Ever Change?

Despite the majority of bonds having a fixed term to maturity, there are occasions where an agreed term is subject to change. This is due to 3 different types of provisions:

  1. A Call Provision: Enables a company to prematurely pay off its bond. This usually occurs when interest rates decline, offering companies the advantage of paying off old bonds at a significantly lower cost and issuing new ones with reduced return rates.
  2. A Put Provision: Allows an investor to sell their bond back to a company, at the price they initially purchased it for. Investors will often do this if they need the money and wish to make another investment.
  3. A Conversion Provision: Permits an investor to transform their purchased bond into shares of stock in their chosen company.

Why Do Companies Sell Corporate Bonds?

The key reason a company will issue a bond is to raise capital. For instance, a company may use the money you lend them to finance new projects, fund an acquisition, subsidise expansion, and so on.

Companies consider bonds one of the most powerful tools when it comes to promoting company growth, as they can raise money at a rapid pace while enabling a company to establish explicitly defined terms regarding interest payments and the time at which the bond matures.

How Are Corporate Bonds Rated?

In order to establish the rating of a corporate bond, an external rating agency will assign credit ratings to a company which is issuing the corporate bond, and subsequently assess the worthiness of their credit.

This helps investors to determine the likelihood that issuers (companies) will pay back the loan with interest payments, in keeping with the agreed interest rates and time frame.

There are two credit classifications that corporate bonds fall into:

  1. Investment-grade: These bonds have high credit ratings and a notably low risk of default. Investment grade bonds additionally offer lower yields and are usually issued with longer maturity terms.
  2. Speculative-grade: Alternatively referred to as ‘sub-investment grade' or ‘junk bonds', these bonds have lower credit ratings and tend to have higher volatility (such as suddenly rising interest rates).

How Do Corporate Bonds Differ?

In this section, we will show you the 4 major components which characterise corporate bonds and cause them to vary…

Yield

The yield of a corporate bond is the annual return that an investor can expect to receive, so long as the bond reaches its maturity. Yields are presented as annual percentages and essentially reflect the price at which a bond was purchased.

The general rule of thumb, when examining yields, is that if the current yield environment sees a decline, the prices of the bonds will increase.

Risk

You can't avoid risks when purchasing corporate bonds, but you can select a bond with lower levels of risk. The risk of a bond is dependent upon the likelihood that an issuer will default on their payments. If you are weighing out the risks of different bonds, check out the rating given by credit agencies.

Par Value

In the world of finance and accounting, the term par value is used to describe the face-value of a bond. Par value indicates two important things: (1) the value of coupon payments and (2) the maturity value.

When looking into corporate bonds, it is important to understand that par value can fluctuate, because corporate bonds can be traded. This means that market factors, such as interest rates and inflation, will greatly affect the value of a corporate bond.

Length

As highlighted earlier, the term to maturity of corporate bonds can vary in length, with longer-term bonds often having a higher chance of interest rates changing either for the better or worse, and short-term bonds having a low level of risk and predictable returns.

What Are The Major Risks Of Corporate Bonds?

Before purchasing any form of corporate bond, you must acknowledge the potential risks that come with this method of investment. If you have read this far, you will have probably noticed that certain elements impact the riskiness of corporate bonds, such as the term to maturity length.

To prepare you for your investment, the CompareBanks team has listed the following risks that you should look out for:

Event Risk

Although corporate bonds are championed for supplying a steady stream of income, there is always a chance that the company you purchase a corporate bond from will run into unforeseen circumstances, which may cause them to default on their repayment.

Factors which can facilitate an event risk include the restructuring of a company or a corporate takeover. Various scenarios come into play here, such as an acquisition, a leveraged buyout, and a merger. Such occurrences can result in a company gathering additional debt, which they may struggle to repay, especially if interest rates rise at the same time.

Credit Risk

The majority of corporate bonds are known to be debentures. This means that they are unsecured by collateral, meaning repayment is not definitively guaranteed.

As an investor, you must always be conscious of credit risks (sometimes referred to as a ‘default' risk), by evaluating credit ratings. Be wary that institutional investors working in favour of corporate bonds can add to agency credit ratings with their own analysis, causing potentially bias and inaccurate results.

When assessing risks, it is always advisable to employ certain tools and dig a little deeper. Capitalisation ratios and interest-coverage ratios are two traditional tools which can help you to determine any potential credit risk.

Interest Rate Risk

Interest rate risks concern the chances of a bond's overall interest rate declining, which will negatively impact the bond's value. The main cause for this risk is existing bonds dropping in market price as a result of new bonds entering the market, and receiving better rates.

Interest rate risks are measured by the duration of a fixed income's length.

Longer-term bonds are more susceptible to this risk due to higher price sensitivity. Price sensitivity refers to the level at which demand shifts, as the value of products and services change.

What Are The Advantages?

Despite presenting a series of risks, bonds are still popular options for investors. Here's why so many investors turn to corporate bonds:

Variety of Options

From short-term bonds to medium-term bonds, to long-term bonds, you will have the ability to choose from a range of maturity lengths, in keeping with your preferences.

There are also two different types of coupons to choose from when purchasing a bond, floating coupon rates and fixed rates. Floating coupon payments may differ each time due to interest rates, whereas fixed rates ensure the same amount of interest is paid to you until the term of your bond ends.

Liquidity

A corporate bond can be traded in the secondary market, allowing investors to purchase and sell securities once they are issued. This means that investors can benefit from selling their bonds that have increased in value, and buying bonds cheaper.

Steady Income

Although bonds won’t make you a millionaire overnight, they will provide a steady flow of cash into your bank. This is because a company is obligated to pay you back on a fixed term in segments with added interest. This ensures that you are paid a consistent flow of income until your bond reaches its maturity.

The payment frequency is decided by whoever issued the bond and can either be monthly, quarterly, semi-annually or even on the agreed date of maturity.

Portfolio Diversification

Bonds are ideal debt instruments for investors looking to diversify their investment portfolios. This is because they act as great counterbalances to equities, offsetting the impacts of any risks presented by shares, which are purchased from rapidly developing companies.

Corporate Bonds Vs Government Bonds

Government bonds are known as gilts, which work when governments borrow money to financially support public expenditures. Similar to government bonds, there are municipal bonds which are issued by local governments, and sometimes non-profit organisations, making this ideal for anyone interested in ethical investing.

The main differentiator setting gilts apart from corporate bonds is that corporate bonds always offer higher interest rates than a government bond, while government bonds offer less risk and guaranteed returns, so long as the government supplying the bond is stable. 

The type of bond you settle for is entirely down to your risk tolerance and general preferences.

If you are unsure of your risk tolerance or want general advice concerning investment options, it is worth seeking help from a financial advisor.

The Best Corporate Bonds UK

Here are 5 of the best-performing bonds you can buy right now in the UK: 

1. Artemis Corporate Bond

Type of Asset: Fixed-interest 

Key Takeaways: Able to allocate throughout the wider fixed-income market; Investment-grade; Great track record

2. Royal London Corporate Bond 

Type of Asset: Fixed-interest 

Key Takeaways: Highly risk-aware; Focused on providing a steady income; Adequately diversified

3. Janus Henderson Strategic Bond Fund

Type of Asset: Fixed-interest

Key Takeaways: Hedges its assets; Provide both corporate and government bonds; Focused on high-yield bonds

4. Invesco Corporate Bond

Type of Assets: Fixed-interest

Key Takeaways: Take a proactive approach; Track record with strong returns; Focused on identifying missed opportunities

5. Black Rock Corporate Bonds

Type of Asset: Fixed Interest

Key Takeaways: Flexible funds; Supported by top-notch risk analytics tools; Offer support from professional fixed-income analysts

The Bottom Line

Just like any other investment, corporate bonds will always present risks. However, this should not dishearten you from purchasing a bond. If you believe you have a suitable risk tolerance and feel confident that you completely understand how these bonds work, then there is no reason why you shouldn't consider purchasing them.

Always be sure to thoroughly evaluate the risks by checking credit ratings from third-party agencies, and through the use of investment tools so that you are adequately prepared to make an investment.

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