Investors face a constant dilemma over which assets, such as shares, bonds and property, to invest in.
The answer is often that a mix of assets can help meet your goals. Different investments can perform well at different times.
For example, when shares languish, government or corporate bonds may fare better. This is considered to be sensible diversification.
With that in mind, we explain one of the assets that may be used to diversify away from equities – corporate bonds.
What is a corporate bond?
A corporate bond is company debt. If a company needs to borrow money it can go to a bank and ask for a loan or it can issue a bond for investors to buy. The financial industry sometimes refers to these types of investments as ‘credit’.
Why would a company issue a bond rather than borrow from a bank?
Companies have to pay interest on the money they borrow. If they think they can borrow the money with better terms from investors they will issue a bond.
What do I get in return for investing in corporate bonds?
You will receive a regular interest payment, which is also referred to as a coupon, usually once or twice a year, for the duration of the bond. At the end of the term of the bond, which is pre-agreed, the company should pay you your money back.
How much interest will I receive from a bond?
The interest rate is determined by a number of factors.
The duration of the bond has a strong influence. In general, the longer the duration, the higher the interest rate, with investors rewarded for giving up their money for longer periods.
The quality of the company will also affect the interest rate. When there is a greater risk of a company defaulting (not being able to pay back the bond), investors will expect higher interest payments.
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This also helps explain why some government bonds pay such low interest rates: because investors believe a government is more likely than a company to return their money.
To help investors evaluate the risk of a company defaulting, ratings agencies such as Moody’s, Fitch and Standard and Poor’s will assess the quality of the bond. For example, Standard and Poor’s will give a bond a rating between “AAA” (highest standard – least likely to default) and “D” (junk – more likely to default), according to its own scale.
Bonds that pay more interest – and the funds that invest in them – are known as high-yield.
Do I receive any other benefits from being a bondholder?
As a creditor to the company, a major benefit of being a bondholder is that you are higher on the list of investors when it comes to getting your money back if the company were to fail.
Shareholders, in contrast, are owners rather than lenders and are among the last to receive any pay out. Shareholders, in fact, rarely receive anything in the event of bankruptcy.
So, should I buy corporate bonds and not shares?
As always in investing there is a risk-reward trade-off. Over very long periods, shares have tended to return more than corporate bonds, but they tend to carry more risk.
The gap in performance between the two types of asset has been less pronounced in recent times.
Since 2000, global shares have grown annually at 6.5 per cent compared with 5.4 per cent for global corporate bonds on a total return basis (which includes dividends/interest payments and capital gains).The figures are based on the Bank of America ML Global Corporate index and the MSCI World Equities index. As always, it should be remembered that past performance is not a guide to future performance and may not be repeated.
So why would I consider investing in company bonds rather than shares?
One argument is that bonds tend to offer a smoother ride because their interest payments are often fixed, and contribute significantly to the total return of the bond. The better long-term gains of shares over the last 17 years hide their erratic (volatile) performance.
As the chart below shows, investors in shares would have needed to keep their nerve over the last two decades.
For example, in 2008, at the height of the global financial crisis, shares were down 40.3 per cent from 2007 as investors sold their holdings fearing economic collapse. A year later they were up 30.8% after those fears faded. In the same period, corporate bonds fell just 4.7 per cent and rose 16.3 per cent.
Over the last decade, on an annual basis, the real return, including inflation, of UK and US corporate bonds has been 2.5 per cent and 4.2 per cent respectively. That compares with 2.3 per cent and 4.9 per cent for UK and US shares respectively.
A reason to hold bonds in addition to shares is diversification. Sometimes when bond prices rise in a market, share prices fall, and vice versa. There’s never any guarantee of this but it’s fair to say that the relative stability of corporate bonds could help balance a portfolio and smooth those years when markets are more volatile.
Corporate bonds vs global equities
Year-on-year performance (%)
Source: Schroders. Thomson Retuers Datastream and Bloomberg data correct as at 8 December 2017. Corporate bonds: BofAML Global Corporate Index. Equities: MSCI World Index (local currency). All indices are valued on a total return basis (including dividends/interest payments and capital gains). This material is not intended to provide advice of any kind. Past performance is not a guide to future performance and may not be repeated. There can be no guarantee as to the magnitude of any future market movements.