Cauta Capital discusses why corporate bonds are a good investment and how they compare to shares.
The dilemma facing investors is usually which assets to invest in – shares, property, bonds? And there is no simple answer. It depends on your portfolio, your financial status and what you need the investments for.
Often, a mix of assets are the best bet. Holding a portfolio of different investments means that they’ll work for you at different times, depending on external forces such as interest rates.
When shares topple, often Government or corporate bonds work out better, for example. This is standard diversification for investors. Here’s why corporate bonds are a good choice as an asset class diversifying away from equities.
How does a corporate bond work?
The easiest way to think of a corporate bond is as a business debt. If a company needs more money, either to expand or for other activities, then the traditional choice is a bank loan. However, over recent years, corporate bonds have become a viable and useful option for companies. This is when they issue a specific bond for investors to buy at a set rate of interest (known as the coupon).
If you’re wondering why a company would choose to do that, think about the interest they would have to pay a bank on their loan. By selling bonds to investors, they can get better terms.
What do investors get?
A regular interest payment, which is known as a coupon in financial circles, is paid regularly. This is usually once or twice a year but varies from bond to bond. You’ll get this for the whole lifespan of the bond, at the end of which, you’ll get your initial investment amount back.
The rate of interest on a corporate bond is decided by the company and is based on various factors. How long the bond’s duration runs for is a major part of this. In general terms, the longer the bond duration, the higher the rate of interest. Investors are essentially rewarded by investing for longer time periods.
The kind of company the bond issuer is will also play a factor. If it a long-established, trusted company or bank, then it’s considered lower risk. On the flipside, if the company is small, new or unstable, then the risk to the investor is much higher and therefore they’d expect higher interest payments.
This is why Government bonds tends to pay low interest rates as they are considered extremely safe for investors to pay into. In theory, a Government is far more likely to always be able to pay the investor their money back, when compared with a company in the private sector.
How can an investor work out the risks?
There are various ratings agencies that are designed specifically to help investors understand the risk of the corporate bond they’re considering. Agencies including Fitch and Standard and Moody’s assess the bond’s quality and consider how likely the company is to default on the bond. They each have their own scale, but will be similar to an AAA rating for the highest standard of company bond, down to E for a ‘junk’ bond, that is, one deemed more likely to default.
Corporate bond investors will benefit from being high up on the list to get their money back, should the company fail. They will come before shareholders, for example, who directly own parts of the company and are generally the last to be compensated in these circumstances.
Why invest in a corporate bond instead of shares?
There is always a trade-off for investors in terms of risk and reward. Over lengthy time periods, shares will generally return more than bonds. But they are also higher risk.
Since 2000, global corporate bonds have grown by 5.4% annually. Compare this with global shares, which have grown at 6.5% annually over the same time period, and the gap between these two different investment options is not as wide as it once was. These figures are based on the MSCI World Equities Index and the Bank of America ML Global Corporate Bond Index.
Having said that, these figures should not be relied upon for future decisions, as past performance has no bearing on what could happen in the future.
Because corporate bonds have fixed interest payments, they offer investors a smoother, more predictable investment than shares. Long-term gains over 20 years might look good for shares, but they will be subject to many erratic dips and rises along the way. So, it partly depends on how much nerve an investor has, and how much volatility they can deal with.
Over the last ten years, the real return (this includes inflation) on both UK and US corporate bonds has been 2.5% and 4.2%. Shares, on the other hand, have been 2.3% and 4.9%. This is because of the extreme ups and downs caused by the global financial crisis in 2008. Shares had fallen in that year by 40.3% from 2007, due to fears of widespread economic collapse. By 2009 they were up again by 30.8% as fears died down. Corporate bonds during the same market fluctuations fell only 4.7% and went up by 16.3%.
Bonds hold their form better than shares, are more predictable, more reliable and work well in a diversified portfolio in particular. There is no guarantee in the world of investments, but it’s reasonable to think that corporate bonds are relatively stable. As such they can smooth out an investment portfolio during tough times.
About Cauta Capital
Cauta Capital is a UK-based company, investing in asset-backed property developments, secured joint ventures and private equity projects.