As interest rates fall, investors are being advised to look to corporate bonds, writes Fiona Reddan

WHEN THE credit crisis first blew up, corporate bonds were hit hard as spreads widened and prices fell. Now, however, government guarantees have put back-stops under the price of financial bonds, while falling interest rates are making bonds more attractive.

Writing in this paper a number of weeks ago, Charlie Fell recommended investors look to investment-grade corporate bonds as "the yields on offer are unlikely to come down until volatility subsides".

John Power, head of corporate bonds, Bloxham Stockbrokers, also favours bonds, saying that the returns available now are "as high as they've been in a generation".

But what are corporate bonds, what are "yields", why are they more attractive when interest rates fall and how can you invest in them?

What is a corporate bond? How does it differ to government bonds?

A corporate bond is a loan to a company. In return for the investment, the company agrees to pay you a certain amount of interest, or a "coupon" over a fixed period of time. Bonds typically have a maturity of anywhere from one day up to 30 years. "Short-term notes" last for up to five years; "intermediate notes/bonds" have maturities of five to 12 years, and "long-term bonds" have maturities of 12 or more years.

Upon maturity of the bond, the corporate repays the principal amount, known as the "par value". Sometimes repayment is made earlier when the corporate "calls" the bond. Bonds are often described as "fixed income" securities because they pay regular, pre-determined interest over a set period of time through the coupon.

The main difference between a corporate and government bond is the degree of risk. Government bonds - where you are effectively lending to the government - are considered to be of the very highest credit quality, and as such are not subject to credit ratings. Corporate bonds are rated depending on the risk of default.

Why do the interest rates from corporate bonds differ?

In general with investments the higher the possible rate of return, the higher the risk - and it is the same with corporate bonds. Generally speaking, the safer a company is, the lower the rate of interest on offer, while the more risky a company is, then the better the rate of return.

But how does the average investor know how risky a company is? This is where the rating agencies come in. Bond rating firms such as Standard Poor's, Moody's and Fitch use a combination of letters and numbers to rate corporate bonds. Investment grade bonds typically have a rating of Aaa, Aa1 or Baa1, according to Moody's designations, while anything below this, for example Ba1 or B1, is considered to be of a low credit quality and is commonly referred to as a "junk bond".

For example, Moody's rates the bonds of computer firm IBM as A1, indicating that they are of investment grade, while Weight Watchers has a rating of Ba1, which means it is "high yield" or "speculative".

However, the methods used by the rating agencies to assess risk have been somewhat discredited by the credit crisis, and they have been blamed in some quarters for actually helping to cause the crisis by inaccurately measuring the risk associated with certain products. As a result, regulation is to be introduced in Europe for this previously unregulated sector.

What this means for an investor is that they shouldn't blindly base their investment choice on a credit rating. "You wouldn't base your investment thesis on just what a rating agency says," Power says.

What are the benefits of investing in corporate bonds?

The main advantage of investing in bonds is that they provide a fixed source of income, which companies can't cancel, and as such offer a greater degree of certainty than equities, even those paying dividends.

Traditionally popular with more conservative investors, most investors should consider allocating a portion of their portfolio to bonds.

Bonds have a typical investment period of between two and 10 years, and are particularly attractive now because of falling interest rates, as well as the tougher credit environment, which means that even the best companies have to pay a premium to attract investors. According to Power, with the prospect of deflation on the horizon, bonds may become even more attractive, with real returns on offer in excess of the coupon.

What are the risks?

The main risk associated with buying corporate bonds is that the company might default on the interest it pays on the bond, the "annual coupon", or on the capital repayment at the end of the term.

While Power says defaults are still very much in the "huge minority", the current environment has led to an increase in corporates going under - and this is likely to increase. Most recently, department store Woolworths went into administration leaving its bondholders high and dry.

Closer to home, Waterford Wedgwood is currently relying on the forbearance of its bankers after missing an interest payment to bondholders some weeks ago.

However, if a company gets into trouble, it must pay interest to bondholders before they pay dividends to both common and preferred shareholders.

Power estimates the recovery value of a bond to be about 40 cents in the dollar, but this depends on circumstances.

Another risk is that the price of a bond could fall, due to an increase in interest rates or a rating downgrade.

How is return calculated?

To assess how your share portfolio has performed, you can simply check the price of the shares. With bonds, however, price isn't as important as "yield", which is the return you actually earn on the bond, based on both the price you paid and the interest payment, or "coupon" you receive.

The "current yield" shows the annual return on your investment in the bond, and is derived by dividing the bond's interest payment by its purchase price. For example, if you paid €100 for a bond with an interest rate of 6 per cent (€6), then the current yield is 6 per cent (€6 divided by €100).

A better indicator of a bond's performance however is its "yield to maturity", which factors in the time value of money and tells you the total return you will receive by holding the bond until it matures. This enables you to compare bonds with different maturities and coupons but, as its calculation is beyond the scope of this article, investors should check with a financial adviser for this before purchasing.

The price of a bond is not static, and it fluctuates in response to changing interest rates. When interest rates rise, bond yields fall and vice versa. This is why, in times of buoyant economic growth, bonds are less attractive because strong growth can lead to inflation which leads to increased interest rates. For investors who hold the bond until maturity, the price is not important.

Is a junk bond as bad an investment as its name suggests?

Also known as a "high-yield bond" or a "speculative bond", a junk bond carries a rating of BB or lower because of the high risk of default. For example, the bonds of International Securities Trading Corporation (ISTC), the investment vehicle established by Tiarnan O'Mahony to lend to financial institutions, were downgraded to junk bond status with a CCC rating following its difficulties as a result of the credit crunch.

However, despite the name, junk bonds are not always a bad investment and are aimed at investors who are prepared to take on more risk. Seen as a speculative investment, in return for the higher level of risk, junk bonds typically offer higher interest rates than safer bonds.

There are two types of junk bonds: "fallen angel" bonds that were once investment grade but have since been downgraded to junk bond status; and "rising stars", bonds that are on their way to being investment quality.

Lower rated bonds now have to offer greater premiums to attract investors - sometimes with a coupon as high as 11 or 12 per cent. For example, benchmark bonds offered by car manufacturer General Motors, which are rated as junk or non-investment grade, are currently yielding about 33 per cent.

However, Power advises that with attractive returns now available on "safe names", there is no need to chase poor quality in the current environment.

How do I invest in corporate bonds?

LIKE EQUITIES, investors have two main options when purchasing corporate bonds - they can purchase the bond outright through a stockbroker or invest through a fund.

Investors looking to invest in a specific bond might consider one of the recent investment-grade issues from an Irish bank, which come with a Government guarantee. For example, last month Bank of Ireland raised €2 billion by issuing Government guaranteed two-year bonds. The bonds pay a coupon, or income, of 3.75 per cent.

At first, this might appear low compared to deposit rates on offer, but, in a period of declining interest rates, investors should remember that this return is guaranteed over the life-time of the bond.

For investors looking for a greater return, and who are prepared to assume slightly more risk, they should consider other investment-grade bonds. For example, IBM, which has a debt rating of A1, recently issued $4 billion in corporate bonds, with coupons ranging from 6.5 per cent for five-year maturities to 8 per cent for 30-year debt.

In general, John Power says investors should focus on solid companies that are sure to survive the recession.

If purchasing a bond outright sounds a bit complicated, the easier option is to invest in a bond fund.

There are currently a number of such funds on offer to Irish investors, including Standard Life's Corporate Bond and the Robeco High Yield Bonds Fund, which is available through Rabodirect, and which invests in high yield or "junk" corporate bonds, involving higher risk than traditional bonds.

Alternatively, investors can access corporate bonds by purchasing an exchange-traded fund through a stockbroker. One of the biggest is the iShares Corporate Bond fund, which is managed by Barclays Global Investors, and which tracks the Markit iBoxx Euro Liquid Corporates Index, investing in euro-denominated investment grade bonds across a range of sectors.

Another option is to get exposure to corporate bonds through a broader fixed income fund. The Canada Life/Setanta Fixed Interest Fund invests in both government gilts and corporate bonds, predominantly from Eurozone countries.