Corporate bonds are perhaps not the most exciting investment opportunity available (see: how to invest in land or investing in commodities). This guide to investing in corporate bonds will explain why corporate bonds are nevertheless one of the most popular types of investments.
For armchair investors to pension managers; the corporate bond has been generating income for investment portfolios for centuries.
I’ve created this ultimate guide to highlight the strengths of this humble workhorse, and explain how you can invest in corporate bonds.
What are corporate bonds
Corporate bonds are an effective way for medium to large corporations to raise finance. When companies ‘issue bonds’, they go out to the market and propose a total size and interest rate.
If investors accept the deal, the transaction is done and the company receives the much-needed capital to invest in the business.
After the issue, the company is obligated to pay the stated interest (known as a coupon payment) and the final sum to the bondholders.
Why don’t corporations take out bank loans instead?
Bank loans feel more straight-forward than issuing corporate bonds.
Instead of negotiating with ‘the market’, the finer details can be agreed over lunch with a group of bank managers. What’s not to like?
So why do companies choose to issue corporate bonds to demanding investors rather than talking to their bank?
Usually, the answer is that the company already has finance arranged with their bank. Virtually all corporations have a ‘revolving credit facility’, which acts like a giant overdraft to ensure they have cash in a crisis.
However, banks are risk-averse when lending their own capital and are only prepared to extend financing up to a limit. They are usually not prepared to extend large, long term loans for companies to finance themselves indefinitely.
We might think of banks as gigantic organisations, but the amount of credit that multinationals need would overwhelm a single bank or even a consortium of them.
How large are we talking?
Taking Apple Inc as an example, its debts total $80 billion. That’s twice as much as Goldman Sachs makes in fee income each year. Just like any investor, banks are wary of placing too many eggs in a single basket.
The corporate bond markets, on the other hand, are home to thousands of participants with very deep pockets. When these investors come together, they can loan vast sums of money with relative ease.
In 2013, US telecom giant Verizon issued corporate bonds worth more than the economy of Libya produced in the same year ($49 billion).
Why do investors favour corporate bonds?
Corporate bonds are like the ‘Coca Cola of investments’. They’re a default investment choice do feature in most basic investment portfolios.
What makes these simple loan agreements so special? Do they deserve their status as a core asset class in many portfolios?
Yes, they do. For several reasons:
- Corporate bonds are suitable for a wider range of investors than stocks and shares. They appeal to both the cautious and adventurous (See: Junk Bonds).
- Corporate bonds generate a ‘premium return’ above savings accounts, which have been proven to beat inflation over the long run. This is a key objective of many investors.
- Buying corporate bonds is objectively more conservative than buying shares. This makes bonds an attractive idea to professionals who have been entrusted to manage other peoples money responsibly, such as pension fund administrators.
- There’s a plentiful supply of corporate bond opportunities. Investors can spread their money across hundreds of corporate bonds to diversify against the risk of any individual company failing,
- The corporate bond market is vast and liquid. This opens the doors to large institutions who can invest at scale without worrying that their trades are distorting prices.
How to invest in corporate bonds
Now that I’ve explained what corporate bonds are, and why they’re loved by investors, I want to outline how to actually buy corporate bonds.
As a private investor, you have three main options to access corporate bonds:
Invest in a collective investment scheme [Recommended for beginners]
A collective scheme (such as an exchange-traded fund) will pool your money with other investors and spread it across a ready-made portfolio of corporate bonds.
Buy corporate bonds via a stockbroker [Expensive, not worth it]
If you choose a stockbroker with lots of features, you’ll be able to buy corporate bonds from other investors on the live market. Minimum investments tend to be high though. This inflates the cost of diversifying across enough individual bonds to spread risk.
Participate in a corporate bond issue [Sophisticated investors only]
These ‘direct to the public’ issues are also known as ‘mini-bonds’. If you’ve heard of them recently in the press, it will be because the UK investment regulator recently banned their sale to retail investors. Take from that what you will. Mini-bonds also happen to feature in my ultimate guide to investment scams. Again – not a great sign.
How to invest in corporate bonds via a collective investment scheme
Investing in bonds through a ‘fund’ of some form is both simple and cost-effective. Of the three investment routes, the fund option is a clear standout winner from my perspective.
If avoiding or reducing investment costs is your priority, then a passive corporate bond fund will tick your box. These funds are managed dispassionately by a fund manager who simply aligns the composition of the fund to a major bond index, such as the catchily named ‘Bloomberg Barclays GBP Non-Government Float Adjusted Bond Index‘.
Ongoing fees on these funds are impressively slim; Vanguard’s U.K. Investment Grade Bond Index Fund – Income (GBP) has an annual charge of 0.12% at the time of writing. For that charge, you get access to over a thousand high-quality bonds.
How to invest in corporate bonds via a stockbroker
Despite what their name might suggest, most full-service stockbrokers are as happy to help you buy bonds as they are stocks and shares.
However, be aware that buying corporate bonds is a costly and bumpy experience.
Unlike shares, which are primarily traded on stock exchanges, most bond trading occurs ‘Over The Counter’ (OTC). OTC trading involves large organisations trading directly with each other rather than through an exchange.
OTC trading reduces the transparency of pricing and locks out smaller players. As a retail investor, you will only be able to access the market via a telephone call to a specialist at your broker.
Fees for this type of trading will be significantly higher than the £8 fees you might pay to buy shares online.
And let’s not forget the context. Corporate bonds earn a lower return than shares, so those premium fees could really eat into your returns if you’re investing modest sums.
What proportion of a portfolio should be allocated to corporate bonds?
Now that you understand the different ways to invest in corporate bonds, its time to consider for yourself whether the bond asset class deserves a place in your portfolio.
If they will feature, how much should you apportion to them?
Well, I host a wide range of example portfolios in my article how to build an investment portfolio, so I recommend you head there next to continue your corporate bond adventure.