New series: A Guide to Investing
Corporate bonds can offer a good return on your money
In the second of a series of extracts from his recently published book, Richard Leeson takes readers through some of the basics you need to know about investing. This week: corporate bonds
Introducing corporate bonds
Corporate bonds are much like gilts, but instead of lending money to the Government the investor lends money to a business. This can give the investor a higher interest rate than from deposits and the company can pay lower rates to borrow by cutting out the bank in the middle.
Gilts are backed by the Government, while corporate bonds are backed by the company and the credit-worthiness of the company is important. You are risking not just your interest but also your capital, as a company might “default”, that is, fail to pay the interest in full and, in extreme situations, fail to pay you back your capital.
The shorter the term of the corporate bond, the lower the rate of return and the lower the risk of default. You need to be careful about who you lend money to, which is why credit-worthiness is really important and it is usually measured by credit ratings agencies.
In the nineteenth century there were a lot of companies building railways in North America and investors wanted to avoid losing their money if these companies went bust (which a number did). Henry Varnum Poor published analyses of the financial health of railway companies. The information he provided allowed people to assess how creditworthy the businesses were and this gave birth to the first credit rating agency.
Today there are three major agencies: Standard and Poor’s (S&P), Moody’s and Fitch. They each provide a ranking of credit-worthiness. You will probably have heard of “AAA” credit ratings, which are the highest credit rating that can be given. Both countries and companies are credit-rated. The former are called sovereign credit ratings and the latter are corporate bond ratings.
The S&P AAA rating means that the country or company has an “extremely strong capacity to meet financial commitments”. What does that mean? It means that it is very safe, but not guaranteed. The ratings are not an indication that you should buy (or sell) investments.
There are a range of credit ratings: BBB and above are termed “investment grade”, while ratings BB to D, are termed “junk” status. The lower the credit rating, the higher the interest rate that the company or government needs to pay to encourage investors to lend them money. Which leads to a very important golden rule: the higher the risk attached to an investment, the higher the potential return you should expect from it.
If you are lending money to a company with a credit rating of AA you will not get as high an interest rate as you will from lending money to a company with a credit rating of BBB. A loan to a company with a BBB rating is higher risk and that risk is compensated for with higher interest. Clearly, though, you would expect a company with an AA rating to be safer than one with a BBB rating and you would run less risk of losing your money.
A word of caution: the Financial Services Compensation Scheme pays compensation if a bank or building society goes bust. There is no such protection for corporate bonds.
How and Why To Invest, Making Your Money Make You Money by wealth management expert Richard Leeson is available on Kindle for £4.03 at http://amzn.to/1dga4iS