In essence, a bond, or corporate bond, is nothing more than an IOU. The organisation that offers the IOU (the bond) is known as the “issuer,” while the purchaser is the “investor.”
As nobody would loan their hard-earned money to a third party for nothing, the bond issuer is required to pay the investor, interest payments, (known as a coupon), which are made at a predetermined rate and time.
Bonds are known as fixed-income securities because they provide a fixed amount of interest if you hold on to them until maturity.
Let’s say you purchase £10,000 of an ABC Co 7% 2030 bond, that has a face value of £1.00, an interest rate of 7%, and a duration of 10 years.
You would earn a total of £700 (£10,000 x 7%) of interest per year, for the next 10 years. If your bond is like most and pays interest twice per year, you would receive two payments of £350 a year for 10 years.
When the bond reaches maturity, after a decade, you would get your original £10,000 back, otherwise known as the “principle” sum.
It should be noted that the underlying price of your bond can fluctuate throughout its lifetime, meaning that it could be worth more, or less, than the original £1.00 face value, or par as it is known.
It is also important to understand that the return of your initial capital or principle, is not guaranteed. Bondholders do rank higher than shareholders in a business, and would have a senior claim on any assets if a company got into trouble. However, if the business did collapse and went bankrupt before the maturity date of your bond, you may not get back as much as you invested, or anything at all.
Corporate bond quality and credit ratings are measured by professional rating agencies, such as Standard & Poor’s, or S&P. In theory, investment-grade bonds are rated between AAA and BBB and should be the safest type of bond investments.
The higher the rating the lower the interest rate or coupon paid will be. Remember the page on “risk v reward”, the lower the risk the lower the reward will be.
Bond rating example and potential coupon rate
AAA = 1%
AA = 2%
A = 3%
BBB = 4%
BB = 5%
B = 6%
Unrated = 7%
Governments are sometimes rated AAA, and so their bonds (called Gilts in the UK and Treasury’s in the USA) have a high credit rating, so a low risk of default, which means a lower level of income.
In our example above, AAA-rated bonds earn just 1% per year. (Although 1% sounds very poor, and it is, as I write this book, some Government bonds are currently paying zero interest on your money!)
Bonds in the AA to BBB range are usually issued by large corporations and are still classed as investment grade. You earn a little more on your investment than the AAA bonds, increasing each time you move down the credit score band, as the risk increases with each move.
Bonds rated BB and below are known as high yield bonds or “junk bonds” and are not classed as investment grade. These bonds again offer a higher potential reward of up to 7% interest, and sometimes more, but the risk of default has increased considerably.
High yield bonds are more volatile than corporates and Gilts, and can often behave like stocks when the economy is in trouble, i.e. the issue price of the bond can drop considerably and quickly, meaning you will suffer a capital loss.
Bonds are rarely bought individually by retail investors, they tend to be bought in funds that have hundreds of different bonds within them, and varying levels of risk. This provides a lower-risk option than owning a single bond, although you can still choose to buy a high yield fund if you want to.