Part 2 of our 6 part fixed income educational series
2. Corporate Bonds: The basics
Fixed income assets are defensive and generally provide investors with more secure and stable investments than growth assets such as shares, hybrids and property. An allocation to defensive assets like fixed income results in a better-balanced portfolio. Let’s look further into what are corporate bonds?
A common form of fixed income investment is a ‘bond’. The federal and state governments and many Australian companies borrow money by issuing bonds.
Bonds are basically loans, with the return to investors driven by four factors:
- The face value – the principal that is repaid when the bond matures,
- The price you paid – either the face value if you bought at issue, or the market price paid after the bond was issued,
- The coupon – the steady stream of income paid over the life of the bond,
- The term – the time from issue date to maturity, or the time left to the maturity date if you buy the bond after it was issued.
Corporate bonds are not all alike. Their key features differ from one bond to another, and include:
The Bond Issuer
Companies vary in their financial strength, depending on a range of factors such as their size and position in their industry and how much money they have already borrowed.
The Face Value
This is the nominal value of the bond – the principal lent to the company, which it promises to re-pay when it matures.
This is the annual income paid to investors, expressed as a percentage of the Face Value. When bonds first existed in paper, investors would detach the coupon for that payment and take it to the company’s bank to receive payment.
Coupon payments are usually half-yearly or quarterly and occur on set dates. This means bonds allow investors to accurately forward-plan to match known income from bonds with outgoings. Most other investments don’t have the ability to very accurately forward plan in this way.
You can use our Cash Flow Tool to map out the cash flows on a portfolio of up to 10 XTBs
A bond with a face value of $10,000 and a coupon of 5%, paid semi-annually will provide an income of $500 per year (two payments of $250 per year) until maturity, when the investor receives the last coupon and the $10,000 repayment of principal.
Fixed or floating coupon bonds
Many bonds have a coupon that is fixed. However, some have ‘floating’ coupons pegged to an industry benchmark that offers investors a fixed margin above that benchmark.
Example: A floating coupon bond that tracks the Bank Bill Swap Rate (BBSW) and offers investors 0.75% above this rate would have a coupon referred to as BBSW + 0.75%.
As at October 2016, BBSW was in the region of 1.7% so the total coupon at that time would be 2.45%.
Term to maturity (or tenor)
This is the length of time from the bond being issued until its maturity, when the face value and the final coupon are paid to investors. It can also mean the amount of time left to maturity from the day you are looking at the bond. The term is also known as the bond’s ‘tenor’.
When you invest in a company, it’s important to understand where your investment sits in the capital structure of that company. If the company gets into financial trouble, some securities will be paid out before others and before equity holders (shareholders).
When we talk about ‘corporate bonds’ in this series, we mean “senior unsecured bonds”, which are the bonds the market refers to as ‘the bond market’, and which ASIC refers to as ‘simple corporate bonds’ to distinguish them from more risky subordinated and hybrid securities.
Senior corporate bonds sit above subordinated bonds, which are in turn above hybrid securities, then equities. The lower the ranking in the capital structure, the higher the risk and potential reward associated with that security.
An important practical and day-to-day implication of where securities sit in the capital ranking is the price stability or volatility. Senior bond prices/yields are generally far less volatile than securities below them in the structure such as equities and hybrids. This is important when it comes to the capital stability of your diversified portfolio.
Government and corporate bonds are usually ‘rated’ by a ratings agency. You may have heard of Australia needing to keep its AAA credit rating – the top rating applied to bonds. Fund managers and Super funds demand that issuers have their bonds rated before they will invest. Most funds will not invest in bonds below a certain credit rating. Investment Grade ratings indicate that a rating agency has attributed the issuer with an adequate capacity to meet its obligations.
Where can you get corporate bonds?
Investors can now access the returns from corporate bonds on ASX via securities known as XTBs. Prior to XTBs corporate bonds were only available in the wholesale market, mostly for sophisticated investors and fund managers.
Infographic: Your guide to corporate bonds
Our infographic explains all of these features of corporate bonds in a simple, visual format.