A beginner’s guide to corporate bond markets

I’m just going to say it: bonds are boring, stock markets are exciting. Why? Because stocks are about the future – new products or services being launched, profits increasing, mergers and acquisitions taking place…. The headlines are sexy. Bond markets are more like talking to your accountant at 4pm on a Friday. Why do you need to borrow this money? How will you pay it back? What can go wrong?

But like any good relationship, your investment portfolio needs balance. We need a few boring, reliable bonds in a portfolio to complement the exciting, fun equities.

What is a bond?

In simple terms, a bond is basically a loan. Just as we would go to a bank to get a loan to buy a car or a mortgage to buy a house, companies and governments also need to borrow money sometimes. A company may need a new building or new machines, for example. Similarly, a government might need more money for its health services or a new motorway.

Only instead of going to a bank for a loan, they will ask investors to lend them the money instead. And, in return for lending them the money, the company or government will pay investors a certain level of income on a regular basis until it is time to repay the loan. And, just like us, they can get different types of loans – or in investment terminology, they can issue different types of bonds.

Understanding debt structure

While personal loans fit into two categories – secured or unsecured – the bond market has a scale of debt. Let’s consider the four main types of bonds – from the least to most risky.

Senior secured bonds

These are the least risky, because if a company goes bust, anyone owning these bonds has first dibs on any money the company has left on its books to pay these bonds back. For example, if it was a bond from Tesco, it could be secured against a Tesco supermarket building.

Senior unsecured bonds

Still lower risk but there’s no building to sell to pay back money should things go pear-shaped.

Junior (subordinated) bonds

After the holders of senior bonds have been paid, holders of junior bonds are next in line for a payout.

Convertible bonds

A convertible bond gives the bondholder the right to exchange their bond for shares of the issuing company if certain targets are reached.

Understanding a credit rating

Bonds are given a rating, or a grade, to indicate how likely they are to repay their debt. In investment speak this is called ‘credit quality’. The ratings are awarded by bond-rating agencies, not the issuer. These ratings use a letter system which ranges from AAA (the most likely to pay back the loan) to C (the least likely).

To simplify the jargon, we typically refer to bonds as being either investment grade or high yield. Investment grade means the bonds are considered higher quality and less risky by credit rating agencies. On a factsheet this would generally mean any bond rated AAA to BBB. High yield refers to those bonds rated BB or below, with the risk increasing as you move down the scale. You will typically see yields increase as the ratings decrease. This is because investors want a higher level of income to compensate them for the higher risk they are taking.

Bonds are also “rerated” – usually on a quarterly basis. This can give us what we call fallen angels or rising stars. Fallen angels are bonds that were once investment grade but have been downgraded to high yield. Rising stars are the opposite – the rating has been increased with the company’s improving credit quality. However, this doesn’t mean the bond has become investment grade, it can refer to a B bond rerated to BB as well.

How do I know which bond is right?

At the end of the day the reason behind these different types of bonds is that institutions want money and investors want returns. The terms of these bonds – their structure and whether they are senior or junior etc – are the bargain struck by the two parties, giving a level of risk and return that is acceptable to both.

The comfort of a greater certainty of payment is balanced against the opportunity for a higher return. Senior bonds have the greatest protection from default but offer lower interest. Junior bonds have higher risk of capital loss but offer more income to compensate.

So, a Tesco senior secured bond may pay 2% interest, but an investor will be more certain of being paid, while a Tesco convertible bond may pay 4% interest, but does so because it carries more risk.

How does this work in practice?

TwentyFour Asset Management – the team behind TwentyFour Dynamic Bond fund and TwentyFour Corporate Bond fund, are experts in Asset Backed Securities – the bonds that have collateral behind them.

The BlackRock Corporate Bond fund takes significantly less risk than the average fund in the sector. The majority of its underlying bonds are investment grade with relatively high credit ratings. However, this is a flexible fund, and it can source other ideas from asset backed securities and unrated bonds.

Richard Woolnough, manager of M&G Corporate Bond and M&G Strategic Corporate Bond invests primarily in investment grade debt. However, the latter is more flexible with the ability to invest in high yield bonds, government debt, convertibles, and preference stocks.

The managers of GAM Star Credit Opportunities like buying the junior debt of companies they think are on a solid footing. So, they are buying riskier bonds and getting a better interest, but they are fairly certain the company will not default. It’s an investment style unique to them.

Both SVS Church House Tenax Absolute Return Strategies and Brooks MacDonald Defensive Capital use convertible bonds as part of their wider investment strategies.