Corporate bonds are securities issued by companies, ranging from banks to utilities, providing them with a means to borrow money from investors in exchange for a promise to repay the borrowed capital with interest over a number of years.
As packages of agreed future payments, corporate bonds are useful to a range of investors – from large pension schemes with significant future liabilities to individual investors with a desire for a steady and reliable income stream.
Many people associate corporate bonds with risk. The first of these risks is default – that is, of a bond’s income stream being interrupted or ending prematurely.
Credit ratings agencies, for a fee payable by the bond issuer, will give a rating to a bond, which describes its probability of default – e.g. high ratings such as ‘AAA’ and ‘AA’ for lower risk, and lower ratings ‘A’ and ‘BBB’ for higher risk. To compensate for the risk of default, investors in corporate bonds are rewarded with higher yields than government bonds, which arguably carry no such risk.
The second risk, which is becoming increasingly talked about, is liquidity.
Like any other marketable security, corporate bonds or ‘credit’ can be traded between investors with relative ease. The presence of intermediate counterparties – the brokerage arms of investment banks – has made this process easier. These have facilitated the needs of investment managers to readily sell and buy bonds by providing bids and offers in the credit market.
Brokers are able to provide liquidity this way by being able to take on positions in bonds they buy, which, in aggregate, may amount to sizeable holdings. But recently tightened bank regulations have meant such activities have become costly, as banks are required to hold more capital against holdings of credit bonds.
One of the most significant effects of this development has been a perceptible decline in liquidity in credit markets. This has led some credit market investors to ask whether they should be considering exiting this asset class.
Facing these issues, credit bond investors must ensure they are fully informed with regards to the risks around investing.
The probability of default of corporate bonds is fairly small, to the extent that corporate bond investors are currently being over-rewarded with additional yields over government bonds. It should also be remembered that, in the queue of creditors that would line up to benefit from the proceeds of the winding up of a company that goes bust, bondholders are towards the front, usually after only ‘super senior’ creditors such as banks that have provided loans, but ahead of equity holders in the company.
In addition, however, some credit bonds come with security so that, in the instance of a default, bondholders have direct claims over assets or cashflows that will allow them to claim back what they would have expected to receive under normal repayment schedules. Such security is overlooked by many investors who, by considering only the probability of default, miss out on bonds offering a high likelihood of recovery even though they may have lower credit ratings. Such bonds are often undervalued, less sought after, and relatively less liquid than large, highly rated sought-after bonds.
The increasingly often reported fall in liquidity in credit bond markets has principally affected the traditionally more liquid part of the market; bank brokerage desks never serviced the requirements of investment managers to trade smaller, less well sought-after issues because there was no demand for them to do so. So liquidity in this latter area has changed little, leaving opportunities unchanged. Despite lower overall credit market liquidity, managers with experience in this area of the market continue to be able to build portfolios that provide stable, secure streams of payments.
Investors must be properly equipped to ask themselves what their investment requirements are, and to determine if their understandings of the risks around investing are complete. But if their interest is to find a source of stable income, without the need to sell-out of their investments in the short term, such goals can be met in today’s ‘risky and illiquid’ credit bond markets.
Ewan McAlpine is senior portfolio manager, fixed income at Royal London Asset Management
