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The outlook for corporate bonds

Investment | Fixed Interest

By Justin Modray, published 30 November 2010.
Helpful? 45

With the Bank of England base interest rate still stuck at 0.5% and looking like it'll remain there for some time yet, do corporate bonds hold some appeal?

To get a feel for where bonds might head in future it helps to understand the main factors that affect bond prices.

What affects bond prices?

Gilts and corporate bonds are basically IOUs issued by governments and companies that promise to pay regular interest at a fixed rate before paying back the sum borrowed at a future date (called 'redemption'). So the following factors are likely to have the biggest impact on a bond's price:

Financial strength
When you lend someone money your key concern should be whether they'll pay you back. It's no different with bonds. When a government or company gets into financial difficulties there's a greater chance they're fail to pay interest and/or your money at redemption, so the price of their bonds will usually fall to reflect the increased risk. This is what's happened recently to bonds issued by the Irish Government.

Interest rates
Because bonds pay a fixed rate of interest their price is sensitive to interest rate movements elsewhere. For example, if interest rates rise and you can earn more interest via a savings account, you'd want to pay a lower price for bonds as their fixed rate will look relatively less attractive than before.

Inflation
The higher inflation, the less future interest payments and return of money at redemption will buy compared to today. So if inflation is expected to rise then bond prices are likely to fall, as they become less attractive.

Confidence in other investments
Bonds issued by robust governments are generally seen as being pretty safe in the scheme of things. This means they're often in demand when stockmarkets are other investment types are looking shaky - and rising demand usually means higher prices.

You'll generally find that bonds issued by riskier companies (often called 'high yield' or 'junk' bonds) are most influenced by changes in perceived financial strength while those issued by safer governments and companies (called 'investment grade') are more sensitive to anticipated interest rate and inflationary movements. Also bonds with shorter periods to redemption tend to be less sensitive to interest and inflation rate movements than those with longer redemption dates.

Currency movements will also obviously affect bonds not issued in pounds sterling.

How much income are bonds paying at the moment?

Income is fixed but a bond's price isn't, so the income you'll receive is best measured by a 'yield' calculation. 'Running yield' is the annual income divided by the bond's price and 'redemption yield' also takes into account any gain or loss you'll make at redemption if the price you pay for the bond is different to the redemption price.

For example, BT has a bond paying 8.5p annual income redeeming at 100p in December 2016. Its current price is 122p, so the running yield is 6.9% (8.5/122), but this doesn't take into account the 22p loss you'll make at redemption. The redemption yield, which builds this in, is about 4.3%.

Here are a few redemption yields (before deduction of tax) at the time of writing to give a flavour for how they vary depending on the financial strength of the issuer and the period until redemption:

IssuerRedemption DateRedemption Yield
UK Government 7 Dec 2011 0.6%
UK Government 7 Sept 2020 3.4%
Marks & Spencer 7 Nov 2011 2.3%
Halifax 17 Jan 2014 5.1%
Tesco 13 Dec 2019 4.3%
Provident Financial 14 April 2020 6.8%
Source: bondscape 20/11/10.

How's recent performance been?

Let's take a look at the main IMA unit trust bond sectors:

Sector1 year return3 year return
UK Gilt 2.9% 18.7%
£ Corporate Bond 6.2% 11.0%
£ High Yield Bond 13.1% 19.5%
Global Bonds 5.1% 31.5%
Source: Trustnet 20/11/10. Returns shown bid to bid with net income reinvested.

So, compared to cash, quite reasonable overall.

What's the outlook?

That really depends on your views for interest rates, inflation and the economy in general.

I'm fairly negative on the prospects for the UK economy and believe that interest rates will continue to remain low for at least another couple of years. High oil prices have been the main inflationary driver this year and provided its price doesn't surge again then inflation should start to fall next year, despite the imminent VAT rise. Some argue that governments printing more money (called 'quantitative easing') will push up inflation, but I'm less convinced as I'm not sure much of this money will actually end up being spent.

This would seem to be reasonably good news for corporate bonds shorter term.

However, if economies do struggle then companies and governments will probably find the going tougher, increasing concerns over their financial strength hence pushing down bond prices (although the very safest government bonds might benefit as more investors flock to perceived safety).

As for the next 5-10 years it's hard not to believe that interest rates won't increase, which could push down bond prices longer term, although the possibility of a more rosy economic outlook and lower inflation could help offset the impact.

So overall I'm quite indifferent. I don't see bonds delivering exciting returns but I doubt higher quality bonds will crash either.

Is it worth buying corporate bonds at the moment?

I think it's generally worth holding some in portfolios to hedge other investment types, but as per above I find it hard to get excited by prospects for the next few years.

And with the fixed rate on some savings accounts currently higher than the redemption yield on gilts and higher quality corporate bonds over 5 years, there's a disincentive to buy shorter-dated bonds unless you think their price will rise so you can sell at a profit before redemption.

There is more to bond investing than I can realistically cover in an article, but hopefully this gives you a clear idea of the main principals and what to consider when making bond investment decisions.

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