If you’re looking for an investment that offers a regular income and a known return but are new to corporate bonds, let’s take you through the key mechanics.
Companies usually borrow money in one of two ways. They can borrow from banks, or they can borrow from the market by issuing bonds. Bonds are basically IOUs: they are typically bought by institutional investors, who may then trade them with other investors.
If you buy and hold a bond to maturity – the returns are driven by two main factors.
- The face value reurned when the bond matures
- The steady stream of income known as the coupon.
Corporate bonds are very different to shares. Shares are the ownership of a small portion of a company, while corporate bonds are essentially a loan to the company.
What sets one corporate bond apart from another?
Corporate bonds are not all the same. This is mainly because the companies that issue them vary markedly in terms of their financial strength. The financial strength of a company depends on many things such as; the health of the industry it’s in, the strength of its own business and the amount of money they have borrowed, etc. Two companies that are broadly similar by many measures can be very different in terms of financial risk. However, the bond that is issued by the riskier company is not necessarily a less attractive investment – if it offers a suitably attractive return.
At a basic structural level, corporate bonds differ in three key ways:
This is the nominal value of the bond, which the company promises to pay when the bond matures, in the absence of a default. It may be $10,000 or $100,000 or any value set by the issuer at the time of issue. Once trading of the bond begins, the market value (or price) of the bond can be higher or lower than the face value. The main driver of fluctuations in a bond’s price is interest rates, which we discuss later. Note: The Face Value of each XTB unit is $100. Subject to no issuer default, investors receive $100 for each XTB unit held at maturity. The face value is a known outcome, in the absence of a default, when you invest, unlike the capital value of shares which may vary right up until the day you sell those shares.
The coupon is the annual income paid to investors – it’s expressed as a percentage of the face value. The term coupon reflects the fact that when bonds first existed in physical paper form, they would normally have coupons attached. To be paid, the investor would detach the coupon for a particular payment and take it to the company’s bank. Coupons are the equivalent of dividends for shares, with one key difference – bond issuers are 100% obliged to pay coupons, or risk being in default. Dividends do not have this same level of predictability for the investor – companies can cut, or raise dividends as they see fit and only become payable once they are declared by the company.
Coupons are usually paid quarterly or semi-annually, on specified dates. If a bond with a face value of $100 has a coupon of 5%, paid semi-annually, two payments of $2.50 will be made each year. Bond coupons can be either fixed or floating. This example refers to a fixed-rate bond and these are generally paid six-monthly in Australia.
A floating coupon is usually expressed as a set amount above a floating benchmark. The most common floating benchmark in Australia is called ‘BBSW’, or the three-month bank bill swap rate – a rate used for inter-bank transactions. A floating coupon rate might be BBSW + 0.80%. If BBSW was 1.0% on the rate-setting day, then the next coupon would be 1.8%. Floating-rate coupons are generally paid quarterly. BBSW moves up and down with interest rate expectations and actual rate changes the RBA makes.
Term to maturity
Different bonds also have different terms to maturity (also known as the tenor). This is the period to the maturity date – the date the face value and the final coupon are paid to investors. Of course, an investor does not have to hold a bond to maturity; they may sell it in the market, subject to liquidity, at the prevailing bond price.
How interest rates affect corporate bonds
Prices of fixed-rate bonds are sensitive to interest rate expectations and changes in the cash rate.
All fixed-rate bonds are sensitive to interest rates changes and market expectations of change. How sensitive they are depends on a number of factors, including the term to maturity.
Floating-rate bonds are not as sensitive to interest rate expectations. Floating-rate bonds usually trade in a fairly tight band around their face value. Most ‘floaters’ are issued by banks, which means the credit risk (risk of issuer default) is lower than many other corporates.
What is yield?
Yield, or yield-to-maturity, is the return an investor receives it they buy a bond and hold it until maturity. It is based on the purchase price and assumes that all coupons can be reinvested at the same yield.
What benefits do corporate bonds bring to investment portfolios and SMSFs?
Corporate bonds are defensive. This means they generally don’t follow shares in a downturn, instead they can defend your portfolio. Equities and hybrids tend to move together and are a lot more volatile than corporate bonds. The capital stability of corporate bonds can anchor your portfolio in a similar way to government bonds or Term Deposits (TDs). Unlike other investments, TDs may enjoy the benefit of protection under the Financial Claims Scheme.
Traditionally, corporate bonds have been traded between institutional investors in large parcels of $500,000 – too large for most retail investors or SMSFs. They’ve historically been traded over-the-counter, rather than on ASX, making them hard to access.
A range of choices now on ASX
The last few years has seen the choices available to investors on the ASX open up substantially. First government bonds became available through investing in AGB units and then corporate bonds followed via XTB units. Both solutions allowed investors to select investments that mirrored attributes of individual bonds – known coupon and maturity dates and a known yield before investment. At the same time, the range of ETFs increased considerably, providing investors with more choice than they’d ever had before.
Like all investments, corporate bonds and bond ETFs also have some risks. The main considerations are:
- Credit risk – The risk that the corporate may not pay back the loan and/or default on coupon payments.
- Liquidity risk – Particular corporate bonds may, from time to time, be difficult to sell except at a significant discount to the current market price or the face value.
- Inflation risk – If there is a change in inflation expectations, interest rates are also likely to change. If the expectation is for higher rates of inflation, the market yields of bonds are generally expected to rise and the market prices of bonds are generally expected to fall.
- Currency risk – If you hold an investment that is denominated in a foreign currency, the value of that investment in Australian dollar terms is likely to fall if the Australian dollar rises.