Understanding Corporate Bonds: Direct Investment vs. Bond Funds

Corporate bonds are a financial instrument used by companies to raise capital, essentially acting as a certificate of debt. When an investor purchases a corporate bond, they are lending money to the issuing company in exchange for an IOU. This IOU typically has a maturity date, at which point the principal amount is returned to the investor. In the interim, the bond provides a fixed interest payment, known as the coupon.

Unlike savings accounts, corporate bonds are not protected by the Financial Services Compensation Scheme. Their safety is directly tied to the financial health of the issuing company. Companies perceived as riskier may offer higher coupon rates to attract investors.

The price of a corporate bond can fluctuate in the market before its maturity date. Investors can sell a bond before maturity, potentially at a profit or a loss, depending on market conditions. When bonds trade above their initial value, they are said to be trading above par, and below par when trading lower. Buying a bond at a discount can increase the yield to maturity, while buying above par can lower it.

Investing Approaches

Investors can access corporate bonds through two primary methods: direct investment in individual bonds or indirectly through bond funds.

Direct Investment

Direct investment involves purchasing individual corporate bonds. This can be done through the retail bond market, where bonds are issued with lower minimum investment amounts, often starting from £100 or £1,000. The London Stock Exchange's Order Book for Retail bonds (Orb) was established to facilitate this market. Retail bonds allow companies to raise funds directly from personal investors for growth or to reduce reliance on bank borrowing. However, direct investment means an investor's capital is concentrated in a single company, increasing risk if that company defaults.

Mini-bonds are a type of unlisted product that cannot be traded on exchanges, making early exit impossible. They gained notoriety following the collapse of London Capital & Finance in 2019, which resulted in significant investor losses. Mini-bonds carry substantial risk, as investors can lose their entire investment if the issuing company goes bankrupt.

Bond Funds

Corporate bond funds pool investments from multiple investors to purchase a diverse portfolio of corporate bonds across various companies. This diversification helps to spread risk. Fund managers aim to generate returns through both the income from the bonds held and by actively trading bonds to buy them at a discount or sell them at a premium. However, investing in bond funds involves paying management fees. The value of a bond fund can be affected by interest rate changes and the performance of its underlying holdings. While a fund can offer growth through skillful trading, there is no guarantee that the initial capital invested will be returned if the fund underperforms.

Risks and Considerations

Both direct bond investments and bond funds carry inherent risks, and they are considered investment products, not savings accounts. Key risks include:

• Credit Risk: The risk that the issuing company may default on its debt obligations.
• Market Risk: The risk that bond prices will fall due to rising interest rates or other market factors.
• Liquidity Risk: The risk that a bond may be difficult to sell quickly at a fair price, particularly for unlisted mini-bonds.

Investors are advised to research the financial health of issuing companies thoroughly, examining cash flow, interest cover, and the security backing the bond debt. For those unsure about the complexities of bond investing, seeking independent financial advice is recommended. The Financial Conduct Authority has been exploring ways to reduce barriers for individuals seeking direct investment in larger companies' debt.