Question
As UK interest rates now look like they will remain at their current level for the next 6 to 12 months I wondered if you felt corporate bonds were worth considering as an alternative to the volatility of the stock market and the poor rates of interest paid by bank accounts ? I would intend to trade out of them when interest rates look like going up.Answer
Higher quality corporate bonds aren't a bad place to be during volatile stock markets and your approach sounds sensible. However, there are issues to be aware of:
Bond yields to redemption (i.e. annual equivalent income including interest payments and any gain/loss on the redemption price versus current price) are only around 2-5% for companies at the safer end of the scale. Given you can earn around 3% variable annual interest or 3.5% fixed for a year via 'best buy' savings accounts it begs the question are corporate bonds worth the extra risk when the extra return might be small?
Let's look at a couple of example bonds issued by Severn Trent Water - which should be fairly safe in the scheme of things.
Their 5.25% 100p bond redeeming in December 2014 is trading at around 110p. This means an income yield of about 4.8% (you receive 5.25p on a 110p investment), but given you only receive 100p at redemption you'll lose 10p if you hold until then, which reduces the redemption yield to 2.2% - less appealing.
Severn Trent also has a 6.125% 100p bond redeeming in February 2024, trading at around 115p. This gives an income yield of 5.3% and a yield to redemption of 4.5%.
The income yields are fairly similar, but there's a big difference in redemption yields. That's because bonds with longer periods until redemption are more susceptible to high inflation and interest rates. If inflation is high long term you'd be more concerned over the impact it'll have on the 100p being redeemed in 2024 than in 2014 - so markets price such expectations into bonds accordingly.
The reason I mention this is that short term corporate bond investing is generally safer when bonds are redeeming sooner than later. But then the possible returns currently look lower. Suppose you buy the above 2014 bond at 110p. You collect the 5.25p annual interest, which is nice, and sell in a year's time. Assuming markets think little has changed, you might expect to sell for 110p. But as we're another year closer to the 2014 redemption it might be that markets are only willing to pay 107p to ensure the yield to redemption remains attractive. In that case you've received 5.25p of interest but lost 3p of capital, giving a total return of 2.25p on 110p, equal to about 2% annual interest - not great.
The long dated bond is less likely to suffer in this respect, but a sudden change in future inflationary or interest rate expectations will likely have a greater impact on price (for better or worse) than the short dated bond (it also depends on how much interest a bond is paying - a stat called 'duration' incorporates all this to predict sensitivity to interest rate movements). So if markets predict rising interest rates before you do you might end up having to sell at less than the 115p purchase price, hurting returns.
I don't want to talk you out of buying corporate bonds, but just bear in mind the above risks and be fairly confident you can predict when the tide turns re: interest rates before markets do, so you can (hopefully) get out with a nice profit.
Bonds issued by banks are trading at lower prices (which means higher yields) following the recent downturn, so worth a look if you're comfortable with the risk. But of course, if things really blow up then banks are likely to be on the receiving end which increases the likelihood they'll default on their bonds - which is why markets are currently pricing them lower.
A good place to look at bond prices and yields (aside from a copy of the FT) is www.bondscape.net - click on closing prices under features.
Good luck!
As UK interest rates now look like they will remain at their current level for the next 6 to 12 months I wondered if you felt corporate bonds were worth considering as an alternative to the volatility of the stock market and the poor rates of interest paid by bank accounts ? I would intend to trade out of them when interest rates look like going up.Answer
Higher quality corporate bonds aren't a bad place to be during volatile stock markets and your approach sounds sensible. However, there are issues to be aware of:
Bond yields to redemption (i.e. annual equivalent income including interest payments and any gain/loss on the redemption price versus current price) are only around 2-5% for companies at the safer end of the scale. Given you can earn around 3% variable annual interest or 3.5% fixed for a year via 'best buy' savings accounts it begs the question are corporate bonds worth the extra risk when the extra return might be small?
Let's look at a couple of example bonds issued by Severn Trent Water - which should be fairly safe in the scheme of things.
Their 5.25% 100p bond redeeming in December 2014 is trading at around 110p. This means an income yield of about 4.8% (you receive 5.25p on a 110p investment), but given you only receive 100p at redemption you'll lose 10p if you hold until then, which reduces the redemption yield to 2.2% - less appealing.
Severn Trent also has a 6.125% 100p bond redeeming in February 2024, trading at around 115p. This gives an income yield of 5.3% and a yield to redemption of 4.5%.
The income yields are fairly similar, but there's a big difference in redemption yields. That's because bonds with longer periods until redemption are more susceptible to high inflation and interest rates. If inflation is high long term you'd be more concerned over the impact it'll have on the 100p being redeemed in 2024 than in 2014 - so markets price such expectations into bonds accordingly.
The reason I mention this is that short term corporate bond investing is generally safer when bonds are redeeming sooner than later. But then the possible returns currently look lower. Suppose you buy the above 2014 bond at 110p. You collect the 5.25p annual interest, which is nice, and sell in a year's time. Assuming markets think little has changed, you might expect to sell for 110p. But as we're another year closer to the 2014 redemption it might be that markets are only willing to pay 107p to ensure the yield to redemption remains attractive. In that case you've received 5.25p of interest but lost 3p of capital, giving a total return of 2.25p on 110p, equal to about 2% annual interest - not great.
The long dated bond is less likely to suffer in this respect, but a sudden change in future inflationary or interest rate expectations will likely have a greater impact on price (for better or worse) than the short dated bond (it also depends on how much interest a bond is paying - a stat called 'duration' incorporates all this to predict sensitivity to interest rate movements). So if markets predict rising interest rates before you do you might end up having to sell at less than the 115p purchase price, hurting returns.
I don't want to talk you out of buying corporate bonds, but just bear in mind the above risks and be fairly confident you can predict when the tide turns re: interest rates before markets do, so you can (hopefully) get out with a nice profit.
Bonds issued by banks are trading at lower prices (which means higher yields) following the recent downturn, so worth a look if you're comfortable with the risk. But of course, if things really blow up then banks are likely to be on the receiving end which increases the likelihood they'll default on their bonds - which is why markets are currently pricing them lower.
A good place to look at bond prices and yields (aside from a copy of the FT) is www.bondscape.net - click on closing prices under features.
Good luck!
Read this Q and A at http://www.candidmoney.com/questions/question564.aspx
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