Bonds: A form of debt issued by companies that acts as an IOU
Corporate bonds are popular among investors, typically offering lower risk and higher income than shares.
A new route to investing direct in companies has opened up in recent years from the retail bond market as well as the more risky mini bonds.
Corporate bond funds invest in a number of different firms and help spread risk, but you will end up paying fund manager fees.
We explain why investors like corporate bonds and how to invest.
What is a corporate bond?
Corporate bonds are used as a way of raising money for businesses – it’s essentially a certificate of debt issued by major companies.
When you buy bonds you are lending money to a company in exchange for an IOU. The IOU has a term and at maturity (typically five or ten years) the sum invested is returned in full.
The only thing that might stop this is if the company actually goes bust. The bond also has a coupon – the amount of interest paid, say 5 per cent.
As long as you hold that bond you are paid that coupon every year and if you keep it to maturity you will get your capital back.
Crucially, the coupon is a fixed percentage of the cover price of the bond.
So if you buy a £10,000 ten-year bond with a 5 per cent return, you will receive £500 each year in interest, and after ten years you will get your £10,000 back.
So far this is not so different from a fixed-rate savings account or savings bond, except your bond is an investment and not a savings product, so it is not covered by the Financial Services Compensation Scheme’s £85,000 individual savings protection cover.
Crucially, this means that your bond is only as safe as the company issuing it – something reflected in smaller, more risky firms having to offer higher rates to tempt investors.
Can you sell a corporate bond early?
The key difference in flexibility between a corporate bond and fixed rate savings is that during its lifetime a market-traded corporate bond can be bought and sold and its price will change according to the market.
So if you hold a ten-year corporate bond you personally don’t have to wait ten years to cash in the bond – you could sell it at any point.
But if you do want to sell it on, between its issue and maturity date the bond’s price will rise and fall and at any given moment it may be worth less than you paid for it. Perhaps you would only get £95 for every £100 you invested.
On the other hand it may be worth more and you will be able to make a capital gain on the investment as well.
When bonds are trading above or below their initial level they are said to be trading above or below par. If you buy a corporate bond second-hand, you will get the right to be repaid its value at maturity and its coupon interest rate until then, but paying above or below par for the bond itself will change the income return.
This means that with traded second-hand bonds a yield to maturity is also typically quoted. If you buy at a discount your yield to maturity will be higher than the original coupon rate, and if you buy above par it will be lower.
Direct investing vs bond funds
Typically individual investors have bought corporate bonds through funds. These invest in a number of different firms and help spread risk accordingly. You will end up paying fund manager fees though.
A bond fund manager aims to take advantage of swings in the markets and deliver a return based both on the income from the bonds held in the fund and the extra boost from buying traded bonds below par, or selling them above par.
The problem with a corporate bond fund is that its value depends on its varied holdings and dealings and can be affected by the market’s view on what will happen to interest rates.
Buy in as interest rates are rising and the value of the bonds it holds may fall and so will your holding in the fund. Likewise, if the manager makes a bad call on buying bonds in companies that fold, or if his view that a certain company’s below par bonds will bounce back is wrong, the fund can lose money.
A manager’s ability to trade bonds can give a fund a turbo-charge along with its income return.
But if you bought into a bond fund now and sold out in five years’ time you could also find that you do not get back the capital that you put in if it has not done well.
If you bought an individual bond you would get back your capital in full, as long as the issuing firm didn’t go bust.
On the flipside, a good bond fund could rise in value thanks to some nifty trading and deliver a solid income return and capital growth. Holding a bond fund also spreads risk among many different companies.
By comparison if you just buy a corporate bond from one individual firm you are putting all your eggs in one basket and not spreading risk, but you will also know that if you hold it to maturity (and the firm doesn’t go bust) you will get your money back.
The Financial Conduct Authority is currently looking at plans to remove barriers and give individuals direct access to investing in the corporate debt of much larger companies.
How do retail bonds work?
The London Stock Exchange launched a retail bond market on February 2010 called the Order Book for Retail bonds, known as Orb.
The aim was to encourage more firms to go direct to personal investors with bonds as the minimum investment is lower.
These have been dubbed retail corporate bonds, or just retail bonds, and are bought and sold through brokers and investment platforms.
Popular issues over the years have included Tesco Bank, National Grid and Severn Trent Water bonds.
The minimum investment for this type of bond starts at a low level – sometimes as little as £100 but more usually from £1,000 – and companies use the money raised to grow or to fund their activities, or reduce their reliance on bank borrowing.
These retail bonds are specifically targeted at small investors and are separate from the far larger corporate bond market dominated by institutions.
You can make money on them early if they are trading higher than the initial offer price – but you might lose money if you sell when they are trading lower.
How do mini-bonds work?
Mini-bonds are unlisted products, meaning they cannot be traded and are not to be confused with retail bonds, corporate bonds and gilts – UK government bonds – which can be bought and sold on the London Stock Exchange.
These are bonds issued by firms to investors that cannot be traded on the Orb market, so investors cannot get out early, and are not subject to the same scrutiny that Orb demands.
But they have fallen out of favour following the high profile £236million collapse of London Capital & Finance, which swept away the savings of many elderly and other investors in January 2019, and the failures of a string of others.
Mini-bonds are simply corporate bonds for private investors, so your cash is being lent directly to large businesses.
If all goes well, at the end of the term, your money is given back to you in full – and you keep the interest you’ve banked. But if the company goes bust, you run the risk of losing everything.
A wide range of companies and organisations have launched mini-bonds – sports clubs, solar panel firms, property specialists, a charity, a restaurant chain, a hotelier and a chocolate retailer among them.
What are the risks of retail and mini-bonds?
Financial experts say consumers have welcomed a new investment alternative and expressed a healthy appetite for a savings vehicle which doesn’t mean dead money in a bank account.
However, both mini-bonds and retail bonds are far riskier than high street savings accounts.
They have always come with serious risk warnings, including from This is Money whenever we write about them.
We make the following points when we report on a new mini or retail bond launch.
* Unlike with a savings account, you are not protected by the UK’s Financial Services Compensation Scheme, which guards against losses of up £85,000.
* They are an investment only for those willing to take a risk and do some homework on a firm’s financial strength.
* They often come with perks, which depending on the issuer have ranged from sports tickets to chocolate, but you should resist being distracted by trinkets and focus on the investment case.
* The varying interest rates on retail bonds and mini-bonds reflect the amount of risk attached – generally, the higher the return, the higher the risk.
* You should beware of putting too much of your money into one or just a handful of bonds.
* It’s worth considering a corporate bond fund, which will lend to large firms and spread your risk.
* Bonds held in an Isa can deliver tax-free income, but investors should investigate the potential tax liabilities on individual investments.
We also offer a checklist for buyers to follow on how to research the health of companies and assess the prospects of individual bonds, which is below.
What to check before buying retail bonds and mini-bonds
* Any investor buying individual shares or bonds would be wise to learn the basics of reading a balance sheet.
* When looking at bonds, research all recent reports and accounts from the issuer thoroughly. You can find official stock market announcements including company results on This is Money here.
* Check the cash flow is healthy and consistent. Also look at the interest cover – the ratio which shows how easily a firm will be able to meet interest repayments on its debt. This is calculated by dividing earnings before interest and taxes (known as EBIT) by what it spends on paying interest. Read our guide to doing investment sums like this here.
* It is very important to find out what the bond debt is secured against, and where you would stand in the queue of creditors if the issuer went bust. This should be included in the details of the bond offer but contact the issuer direct if it is unclear.
* Consider whether to spread your risk by buying a bond fund, rather than tying up your money with just one company or organisation.
* Inexperienced investors who are unsure about how retail or mini-bonds bonds work or their potential tax liabilities should seek independent financial advice.
* If the interest rate is what attracts you to the bond, weigh up whether it is truly worth the risk involved. Generally speaking, the higher the rate on offer, the higher the risk.
* If the issuer is a listed company, before you decide whether to buy it is worth checking the dividend yield on the shares to see how it compares with the return on the bond. Share prices, charts and dividend yields can be found on This Is Money here.
* Investors should bear in mind that it can be harder to judge the risk involved in investing in some bonds than in others – it is easier to assess the likelihood of Tesco going bust than smaller and more specialist businesses.
How are interest rate returns decided?
The return a company has to offer on corporate bonds depends on a number of factors – current interest rates, whether they are expected to rise, and crucially how stable that company is seen as.
Some smaller companies may offer corporate bonds paying much larger returns, sometimes nicknamed ‘junk bonds’.
This return has to be higher due to the heightened risk of going bust – so investors should be cautious as to which companies they feel are stable enough to pay out.
If in doubt, get financial advice
Corporate bonds might sound safe but they are an investment not a savings product. If you are an inexperienced investor or do not understand the market, then seek independent financial advice.
This is Money has partnered with Flying Colours to help people find an adviser. It specialises in financial lifestyle planning and helping people to find high quality trustworthy advice from local IFAs.