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The pros and cons of corporate bonds

This article is part of
Guide to Fixed Income Investing

“High quality investment grade corporate bonds usually offer investors an attractive risk/reward balance,” says Kevin Telfer, fixed income product specialist at Kames Capital.

“Whilst there is some credit risk compared to high-quality government bonds, defaults have been historically very low, reflecting investment grade companies’ financial strength.”

The returns on investment grade corporate bonds are by and large sufficient to more than compensate for the additional credit risks over sovereign bonds.

“This often leads investors to hold investment grade corporate bonds as a less defensive alternative to high-quality government bonds,” says Mr Telfer.

Moreover, says Neil Mayfield, principal at Mayfield Investment Management, corporate bonds may even offer a lower risk of default than some government debt.

“The debt can often be secured against assets and the holder is at the front of the queue in the event of default,” he adds.

Some corporate debt might be ‘convertible’, giving investors the option to convert to shares in the company at a set price. As Mr Mayfield says, this offers the security of the bond plus the potential to share in some of the upside of holding shares.

However, when markets are in turmoil, corporate bonds generally underperform government bonds although not as much as, say, equities.

“In times of extreme market stress,” explains Mr Telfer, “the underperformance can be significant, as seen in the credit crunch of 2007 and 2008.

“However, even over that period, whilst investment grade defaults increased the overwhelming majority of companies continued to service their debts and as corporate bond markets bounced back strongly over 2009 and 2010, investors who had held their nerve were very well rewarded.”

But like government bonds, the lower credit quality the company – what is known as sub-investment grade, high yield or ‘junk’ bonds – the credit risks can increase materially.

“The lowest-grade corporate bonds exhibit very little defensive properties and behave more like equities and other risky assets,” says Mr Telfer.

“Investing in corporate bonds can offer investors an attractive income stream. However, one needs to be mindful that bonds or funds offering a very high income stream are often a doing so by taking significant credit risks.”

Added to that, Mr Mayfield cautions that corporate bonds “offer less variety of investments and generally speaking offer more risk than government bonds. The market is also less accessible to private investors.”