Corporate bonds – like loans to companies – guarantee you a rate of interest over a fixed term. So, how do they work, and why should you consider investing in them?
Your savings account isn’t giving you the best return on your money. Easy-access cash savings accounts don’t offer interest rates that match inflation: you’re losing buying power with the money you’ve got saved.
Stocks and shares offer an attractive reward potential – at a higher risk. You could make 10% returns – but you could also lose your investment if the market crashes.
Corporate bonds look like an attractive option now! If you’ve got spare capital to invest, but don’t want the high-risk stakes of the stock market, this could be the right investment vehicle for you.
This is the beginner’s guide to corporate bonds – let’s get started!
- What are corporate bonds?
- Why invest in them?
- How do you invest in them?
- How do I choose corporate bonds?
what are corporate bonds
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. When we borrow 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.
You’re only lending money to the company: you don’t own part of it. If you want to own a bit of a company (and benefit from dividends – profit share payouts), you’ll need to buy shares.
However, lending money to the company puts you in a stronger position than a shareholder. Paying off their debt to you comes before working out profits that get shared amongst shareholders.
If the company goes bust, you’re much higher on the list to get your investment back (or at least some of it) compared to shareholders, too.
How corporate bonds generate income
You earn interest each year from the company. They pay you the set rate of interest agreed when you bought the bond. The longer the term of the bond, the higher the rate of interest – because you’ve tied up your capital for a longer period.
Higher-risk companies also offer higher rates of interest to attract investors. Reliable companies offer lower interest rates – but these are also easier to sell on the secondary market if you want to get your cash back before the end of the term.
At the end of the agreed term, you’ll get your final interest payment and your original payment returned to you.
why invest in them?
You get more money back from corporate bonds than leaving your cash in a savings account. Yet, there is less risk attached to corporate bonds compared to stock market investments.
Bond investors use them as a way to generate a regular, stable income. It’s not the best way to create capital growth; other investment types suit that type of financial strategy better.
Are there any downsides to investing in corporate bonds?
As with any investment, risks and downsides come as part of the package.
- You could lose your investment if the company folds
- You’re tying your capital up for a long time
- Buying above the nominal amount reduces your investment
- You could miss out on a better interest rate later on
- Your money isn’t protected by the Financial Services Compensation Scheme
However, these risks are similar to all investment types. In fact, the risk is still lower than high-stakes stock market investments!
how do you invest in corporate bonds?
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.
Popular online broker platforms to check out include:
With these platforms, you can also put your bonds into a stocks and shares ISA wrapper. This gives you added tax benefits compared to investing outside of the ISA wrapper.
Read our article about investing for beginners to find out more about setting up an online broker account.
Understanding the Nominal Amount
A bond has a nominal amount of £100. You might buy a bond at £95, or £100, or £105: the price changes, as does the interest rate offered.
Buying a bond under the nominal amount offers greater returns than one over it. For example, buying a bond at £105 means you only get £100 back as you’ll get back the nominal value.
Why would you buy above the nominal value, then? Well, if the interest rate is great and you’re willing to tie your capital up for a long time, you could still profit from the interest payments. It’s always better to buy at or below nominal value, if you can.
Can you sell your bonds before the end of the term?
The nominal value is particularly important when you’re selling your bonds. If you want to release your cash, it’s possible to sell your bond on the secondary market.
You’ll need to find a buyer willing to take over your loan. This is easy when the latest interest rates are lower than your agreed rate (the ‘coupon’). Buyers want the highest interest rate possible.
It’s also easier if you sell below nominal value. However, you may not get your full investment back, doing that.
Ideally, you want to sell when prices are above the nominal value. If you bought your bond for £95, for example, you might be able to sell it for £105.
Either way, if you need to release your cash from the bond, and you’re willing to take a potential loss, you can get your money out.
Try Bond Funds Instead
Most people don’t buy individual bonds. Instead, they invest in bond funds. A fund, with a manager, invests in bonds for a number of companies.
Investing in bond funds spreads the risk compared to individual bonds. If a few companies default on their bond loans, the impact is mitigated by other – successful – bond investments.
Instead of offering a fixed rate of return, bonds provide a ‘target return’. It doesn’t guarantee you’ll get that rate – it’s what they aim to achieve.
Unlike buying individual bonds, you can sell your investment in a bond fund whenever you like. You don’t have to wait to find a buyer on the secondary market.
which ones do we like?
You need to look at the investment grades of a bond to assess the risk. A company rated AAA, AA, A, or BBB is a relatively sound investment.
Companies rated below BBB involve more risk. That means the returns on offer are higher – yet you could lose your full investment if the company defaults.
Investing in bond funds is easy with your online platform. An even easier, cheaper way to invest this way is to find an Exchange-Traded Fund (ETF) that tracks bond fund performances. Check out the iShares platform for a great example of this – and then read our article about investing in ETFs here.
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