There is risk attached to all forms of stock market investment and, in this respect, investing in corporate bonds is no exception. The issue for those who are considering investment in corporate bonds is to determine the level of the risk attached, and what measures they should take to safeguard their investment, while at the same time maximising the return on capital and its growth in value. In order to assess how safe corporate bond investment is, it is therefore important to understand firstly, what a corporate bond is and secondly, how the level of risk is reflected within the price and return of the bond.
In simple terms, a corporate bond represents a borrowing option for the firm. In other words, in return for the issuance of the bond and the promise to pay interest to the bond holder during a predetermined period, the firm receives additional funds for use in its operations, much in the same way that it would were it to borrow from a financial institution, such as a bank. The crucial difference with a corporate bond is that the capital invested is not returned until the end of the bond term, although it can be traded on the stock market in much the same way as equity investments. However, unlike shares, the trade in bonds is usually operated at predetermined value levels, for example, £1,000 lots or more.
The main risk attached to corporate bond investment is that, potentially, the corporation might not be in a position to repay its debt at the end of the agreed term, which would be the case if the firm becomes bankrupt and goes into liquidation. In this event, the investor will lose all of their capital. Therefore, the first step in ensuring whether a corporate bond investment is reasonably safe is to assess the financial position of the corporation issuing the bond. There are a number of indicators that can be used in this respect.
The simplest method of assessing the risk attached to a firm is to look at the interest (or coupon) being offered on the bond. The higher this interest rate is the more risk is deemed as being attached to the firm. In other words, high coupons equate to a corporation with weaker financial strength and an increased likelihood of failure. The additional interest is therefore being offered as a reward for risk.
The second method of measuring risk is to be guided by the market information provided by the reputable investment rating agencies, such as Standard and Poor’s. Essentially, part of the market intelligence service provided by Standard and Poor’s involves the provision of credit ratings on financial market investment opportunities, which includes corporate bonds. In this respect, it is generally agreed that the safest bonds for investors are those that are rated at BBB or above. Potentially, the strongest corporations would be those offering bonds that achieve a rating of AA. Bonds that have a lower rating than BBB, often referred to as ‘junk bonds’, are regarded as a higher risk for the investor. In these cases, the lower the credit rating will equate to a higher level of financial instability in the firm issuing the bond.
As mentioned in the introduction, there is no risk-free corporate bond. However, investment in such bonds can be made with a greater degree of safety if the investor follows a few simple rules. Firstly, due to the size of the initial capital investment it is important never to invest more than can be afforded, in terms of both the capital amount and the time span between investment and bond maturity. Secondly, to reduce the risks from speculation it is important to be either guided by the risk results produced by the appropriate rating agencies.