You may get staff questions about bonds, and most insurance companies offer a corporate bond fund option in their defined contribution schemes, says Ceri Jones
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Corporate bonds are loans to companies from investors. The firm repays the original sum upon maturity and pays regular interest. Bonds are traded on stock exchanges their value depends on supply and demand, but in the event of a wind-up bondholders sit ahead of shareholders in claims on the issuer’s assets. Bond funds are generally assumed to be boring but steady investments, and for the cautious can be rewarding.
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Companies have three ways of raising cash. They can issue equity, borrow from a bank, or they can borrow from investors by issuing bonds. Bonds are effectively an IOU, with the company promising to repay the original investment at a maturity date, plus interest payments at regular intervals. Bonds are traded on the Stock Exchange, so their value rises or falls as demand fluctuates. In the UK, bonds are issued in bundles of £100, so if for example, a company agrees to pay bondholders a set amount of £10, the yield is 10%. If the bond is then traded in the market and sold for £110, the income is still £10 but the yield has dropped to 9%.
If, however, demand for the bond is low and the price falls to £90, the yield rises to 11%. An important feature is that corporate bonds are less risky than equities, because if a company fails, bondholders are higher up the pay-out pecking order than shareholders. To help assess a bond’s risk, specialist companies such as Standard & Poor’s, Moody’s and Fitch assign ratings to indicate an issuer’s financial strength.
These are graded in various shades between AAA to C, but as the companies themselves generally pay for this service, a rating of B that sounds attractive on the surface actually denotes a bond that falls short of investment quality. According to a survey by Barclays Capital Corporate, bonds have made 8.5% per year compound after inflation over the last decade compared with 6.5% for gilts (government bonds) and 5% for equities. Broadly speaking, bonds do better when economic conditions are deteriorating because in such circumstances they are chosen in preference to equities. If bonds fall, it usually signals the economy is improving.
This year, there has been talk of overheating in the bond market, but over the long-term, corporate bonds are less volatile than equities. Demographic trends are also in their favour as western populations age and demand remains strong from pensions looking to match liabilities. Most insurance companies offer a corporate bond fund option in their defined contribution pension schemes, and these tend to be marketed as a way for the more cautious investor to generate better returns than cash, while minimising the overall risk of a portfolio.
These funds are something of a half-way house, beating returns from bank deposits but falling short of recent equity fund growth. Several leading fund management groups are beginning to manage bond portfolios with a pro-activity that previously had been reserved for equities. This is beginning to filter through to retail bond funds, some of which now offer excellent returns because of increased emphasis on lower grade high-yielding bonds, emerging market debt and new types of hybrids such as preferred securities.