We have all been diligent investors and moved up the learning curve as it relates to understanding the mechanics of bonds. Like good students, we have kept a keen eye on investment products and are well aware of the Government isssues in the market. Our next lesson will be to take a closer look at corporate bonds. Is this an investment for your portfolio? How much risk is associated with these issues? Let’s take a look.

Definition

By definition a coporate bond is a debt security issued, as the name suggests, by a corporation and sold to investors. The risk profile of the bond is dependent on the financial position of the issuing company. “The financial position” describes the issuing company’s ability to repay its debt and other expenses, profitability, growth prospects among other things. Corporate bonds carry higher risk when compared to government bonds and as such they offer attractive interest rates to entice investors to participate.

Credit quality and its implications

The credit quality of a bond measures the risk that the issuer will default i.e. not repay the investors. Corporate bonds range in credit quality from investment grade to “junk”. Investment grade instruments are rated BBB- and above (AAA+ being the highest credit quality and SD i.e. selective default being the lowest credit quality). Bonds that are not investment grade are classified as “junk”. The credit quality depends on the financial and strategic position of the issuer. For example, bonds issued by companies such as Barclays Bank PLC and General Electric Corporation are considered very safe and are rated A- and AA+ respectively by Standard and Poor’s because of their strong financial positions, their long established histories and the importance of their services to the economy and society.

Features of Corporate Bonds

Corporate bonds may have different features or terms which make their coupons more attractive. The most common feature is referred to as a “call option”. This feature allows the corporation to redeem the bonds before maturity. They may be redeemed on pre-determined dates at which time the company may choose to give back the funds invested (including accrued interest) and the bond would then cease to exist. Callable bonds tend to offer higher coupons because of the risk that the bond may be called and the investor will have to reinvest his funds at a lower interest rate.

Corporate bonds may also have another feature referred to as a “step-up”. A step up bond is a bond that has a fixed coupon rate for a period of time but is designed with conditions which state that the interest rate must increase if specific events occur (or do not occur). For example, if there is a fall in the credit rating of the issuer, the interest rate may increase by a given number of basis points. This feature is often combined with call options. In these cases, if the bonds are not redeemed the coupon will then “step-up” (i.e. adjust) to a new coupon rate. In cases such as these investors should analyze the effective yield to each callable date and then compare it to an alternative investment to assess the relative value of the bond before making a purchase.

The Corporate bond may also be secured or unsecured. A secured bond is simply a bond that has an asset or specific properties as collateral. The perfect example is a mortgage bond where the bond is backed by a pool of mortgages (eg. Bonds issued by Freddie Mac or Fannie Mae). Unsecured bonds are backed solely by the general credit-worthiness of the issuer. It should be noted that most corporate issues are unsecured bonds.

Before choosing any investment, you should sit with your investment advisor and put together a financial plan: outline your goals and clarify your tolerance for risk then ask yourself the following questions:

* How will a corporate bond meet your investment objectives?

* What are its terms and conditions? for example its callable features, step-up rate etc

* How is coupon payment made? Periodically or at the end of the period?

* Will you need the funds before the bond matures?

* What is the credit quality of the bond?

Having answered these questions you are now in a better position to make an intelligent decision regarding your portfolio.

Dian Blackwood is a personal financial planner with Sterling Asset Management Ltd. Sterling provides medium to long term financial advice and instruments in U.S. and other world market currencies to the corporate, individual and institutional investor.

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