Cash ISAs increasingly look like a waste of time. Stocks and shares seem frightening to many people (although they are cheap now so don’t write them off). Suddenly, corporate bonds look interesting. The question is, though, what are they and how do you invest in them?
What they are NOT is they are not savings bonds. Savings bonds are another word for fixed rate savings accounts where you put your money into a savings account for a fixed amount of time. They are about savings, not investment as you can see in our article about fixed rate savings accounts.
Corporate bonds are loans that you make to a company.
It’s like you or me going to the bank and asking for a loan. If they lend us the money we promise to pay it back, with interest, over a certain period of time.
Corporate bonds are like that. The company wants to borrow money so they come to us (through brokers and bond funds) to borrow that money. In return they promise to pay a fixed interest rate every year and then pay the whole lot off at the end of a fixed period.
So, when you buy a corporate bond you are effectively lending money to a company. This is the difference between corporate bonds and shares. When you buy shares in a company you actually buy a bit of that company – you own a very little bit of that company. When you buy corporate bonds you just lend money to the company – you don’t end up owning any of it.
How much you make in interest each year from your lending largely depends on how risky the company is. In other words, what the chances are of them going bust. If they do tank, you could lose all your money. However, many corporate bonds are secured on the assets of the company you’re lending to, in much the same way that a mortgage loan from a bank is secured on your house. So if the company you’re lending to does go bust you may have priority over the company’s assets and you would be among the first to get some money back from the receivers. The amount you may get back, though, will depend on the quality of the company and its underlying assets.
So if a company looks a bit wobbly you would expect to get a higher rate of interest to compensate. However, if it’s a big, solid, low-risk operation you should expect to get less interest.
Recently we’ve seen fairly safe bonds, paying incomes of 7% and more, coming on to the market and being snapped up.
They are worth it mainly because you’re going to get more money back than you would with a cash investment (i.e. putting your money in a savings account), although not as much as you would with shares. However, they’re rather less risky than shares.
In fact, the main reason why many people invest in them is that they usually give a regular, stable income. They’re not generally designed to create capital growth.
However, do remember that there is risk involved. You could lose some money if you go for the riskier, higher-yielding bonds. Or you could just make quite a lot of money!
You can buy actual bonds through most stockbrokers, just like you can buy shares. You will need to set up a trading account with an online stock broker.
However, most people don’t bother trading in individual bonds. They tend to invest in bond ‘funds’. As with stock market ‘funds’, ‘bond funds’ invest in a selection of bonds of different levels of risk. Generally these funds are safer than investing in individual bonds because they spread the risk over many different company bonds – sometimes hundreds. So if a few of these companies don’t pay the loan back, at least you are covered by all the other ones that do.
The downside of bond funds, though, is that because of the mix of investments, the funds can’t promise a fixed return. Instead they aim for what they call a ‘target return’. So you might get a certain interest rate through the year or you might not. Ideally you will get something pretty close to what they offer but there are no guarantees.
Unlike savings bonds, you don’t have to keep your money in these funds for a fixed amount of time. You can buy and sell when you like.
You can invest in bond unit trusts that are managed by guys in the City, just like managed shares funds. However, they tend to charge a lot for doing the managing and they don’t always work very well (often because of the high management charges).
Or, you could invest in them through an Exchange Traded Fund (ETF). Right now you could try the iShares Corporate Bond Exchange Traded Fund (ETF). Like most ETF’s, it is cheap to run so you should make more money. In fact, this one has no up front fees.
Peter Sleep who works with our Investment blogger Justin Urquhart-Stewart at Seven Investments says that this fund includes bonds that are ‘A’ grade or above. Bonds are graded according to how risky the company is considered to be. Really solid companies are graded as ‘AAA’ and it goes down to ‘AA’ then ‘A’ and so on. Anything below ‘BBB’ is considered very risky and referred to as ‘junk’. Bonds that are BBB and above are investment grade bonds.
“This iShares fund has an excellent yield,” says Sleep. “The companies included are all graded at ‘A’ or above and 61% of them are banks. You might be worried about that but remember governments are guaranteeing bank debt so you’re almost getting government-backed bonds at 8.6%!”
Remember, as with other ETF’s, in order to invest in the Corporate Bond ETF above, you will need to set up an account with an online broker first. It’s pretty straightforward to do once you get onto an online broker.