The bond market is currently abuzz with scores of investors investing money in millions in it. Before getting into the details let us first find out what a corporate bond is.
A corporate bond is something similar to a bank fixed deposit. The company issuing the bond accepts your deposit and issues you a certificate as proof of your deposit. During the deposit the company agrees to pay you an interest for your deposit. You can opt for periodic interest payments or one lumpsum payment at maturity. All said and done, there are a few major differences here.
1. The interest offered by corporate bonds are higher than that offered by banks
2. There is no guarantee that you would get your money back. The bond is issued on a best effort basis where the company would try its best to repay your money along with interest provided it is able to make sufficient profit.
Now you know why corporations offer a higher interest rate “To attract investors who are ready to take the risk by offering a higher Return on Investment (RoI)”
Why are Corporate Bonds so attractive now?
With the ongoing financial crisis, the equity markets have slumped to nearly half of its peak value at the beginning of the year 2008. Most investors have lost interest/faith in the stock markets and are considering other avenues of investment which can provide them better returns. Currently bonds are one among the top investment options because they offer a better RoI than bank deposits. Though they come with an inherent risk, most corporations that issue bonds are in pretty sound financial status and the chances of losing our principal is comparatively low. Since bonds are like bank deposits your capital remains intact and hence bonds have become attractive now.
The bonds that are currently being issued offer us returns of around 11% which is nearly 2-3% more than what banks offer us.
Though the returns on corporate bonds are high, they come with their inherent risks. Below are some aspects that you need to check before investing your hard earned money in them.
Default in payment by the bond issuer is one f the major risks that we face while investing in bonds. The default could range from untimely payment of coupons to non payment of principal at maturity.
The chances of default can be found out by the rating assigned to the bond by authorized agencies on the basis of a rating scale. The higher end of the scale indicates better credit quality which means that the chances of default are lesser. Apart from the chances of default, such agencies also consider another risk before assigning a rating. That is the sector specific risk. If an industry is going through a rough patch due to the prevailing economic scenarios then the chances of the company performing well are lesser. Hence this would naturally affect the company’s finances and eventually affect the bond rating.
It is a general thumb rule to choose bonds with good credit ratings over the ones with not so good ratings.
Risk Return Balance
We should analyze our risk appetite before investing in certain bonds. Some company’s offer very high returns but their credit history wouldn’t be so great. Investing in such bonds should be done with caution.
We can compare the returns on existing bonds with a similar rating in the market to find out the kind of returns that we can expect in new issues. But the yield on a particular bond would also depend on the industry in which the bond issuing company operates. For example the yield on an ‘AAA’ bond in a finance industry would be higher than that of an ‘AAA’ bond in a manufacturing industry. But at the same time, investors would prefer manufacturing industry because of the safety of investment and would prefer them over finance bonds.
We must analyze the performance of the issuing company before making our investment.
One of the most important considerations before buying a bond is the liquidity offered. This is important because most bonds are long term investment options wherein your money would get locked in for 5 – 10 years.
Premature selling of bonds would expose us to interest rate risks. For example, when interest rates go up, new bonds start offering higher rates than that of existing bonds. So at such a situation if you want to sell your bond, you would have to sell it for a lower price than what is its current market value.
Also, some corporations may not be able to pay off the bonds if we plan to exit before maturity. Though these securities are listed in registered exchanges, they may not be liquid and you may not be able to sell them at the current market value. You may have to compromise on the selling price while selling such illiquid securities.
Some other factors to be considered before buying such bonds are:
- Do not invest in complex bonds. The simpler they are the better they are for you. For example some bonds give us the option of converting them to that company’s shares. This increases the volatility in price of the bond and it is better to stay away from them.
- Industry situation: Always some industries would outperform its peers and some may underperform. Investing in bonds from industries that are struggling would adversely affect both liquidity and returns on our investments.
- Credibility & Integrity of the Rating agency. Do not just go by the rating given by the rating agency. Analyze the credibility and past history of the agency before believing their rating. Also remember that these ratings are only speculations and do not guarantee the bond performance.