Steer Clear Of Stock Market Storms: Part Two

If you're risk-averse investing in shares is probably the last thing you would do. Could corporate bonds be a better choice for you?

Earlier this week I talked about gilts as an alternative to investing in shares for more cautious investors. Today, while still observing the same principle, I'll move a little further up the risk scale to corporate bonds. Corporate bonds and gilts have a lot in common. While a gilt is a loan to the government, a corporate bond is a loan to a company which provides a fixed interest return (the coupon) until the redemption date in much the same way. They can both be traded which means there is potential for a capital gain if you can sell above the buying price. A corporate bond certainly sounds like a gilt, but why is it more risky? This is all down to the default risk - or the probability you won't get your money back on redemption. As I discussed in my first article, the chances of the UK Government defaulting are next to nothing. But the same can't be said of companies and this is why they involve a greater risk, particularly since the risk of recession lurks in the background. Are Some Bonds More Risky Than Others? The simple answer is yes. Corporate bonds are graded by ratings agencies to assess how creditworthy they are. Standard & Poor's - probably the most well-known ratings agency - uses a scale between AAA and D. The AAA credit rating is awarded to those companies which have the lowest default risk and are not a million miles away from gilts from a risk perspective. At the other end of the scale, a company with a D rating is already in default and has probably gone bust or is on the verge of doing so. Bonds are broadly divided into two main categories, again related to risk. These are investment grade bonds and high yield bonds. Using the same Standard & Poor's scale, investment grade bonds are those which have been awarded credit ratings between AAA and BBB- (or BBB minus). These are deemed to be safer than high yield bonds which receive credit ratings below BBB-. High yields bonds are otherwise known as `junk' bonds but this doesn't necessarily mean they are junk as an investment! Don't assume just because a company currently has a AAA credit rating it will always be a safe bet. Companies are continually reassessed and may be upgraded or downgraded depending on their changing outlook. Why Choose Corporate Bonds Over Gilts? Of course, greater risk has the potential for greater rewards. If you decide to lend to a less creditworthy organisation, you must be compensated for taking that added risk. You can expect to receive a higher income from a bond than you would get from a gilt. Take HBOS, for example, it has a Standard & Poor's credit rating of AA and a current yield of 5.93%. Likewise, Vodafone has a credit rating of A- (A minus) but a higher yield of 6.40%. Compare that to the yield from gilts which are generally running at less than 4.50%.* It's that extra 1% or 2% yield that attracts investors to lend to companies rather than the rock solid Government. Remember the yield continually changes as the purchase price of the bond moves up and down while the coupon rate remains fixed. Like gilt prices, bond prices are influenced by sentiment towards long-term interest rates, inflation and economic growth. But the general health of the company also has a huge impact. If an organisation runs into serious trouble then it's easy to appreciate how an increased default risk can push the bond price down. This in turn, will force the yield up. Corporate Bond Funds An individual corporate bond is usually only bought by professional investors with deep pockets. For everyday investors, like you and me, we can invest in a corporate bond fund run by a fund manager. Just like gilt funds, the manager will trade bonds on our behalf in the hope of achieving the best possible return. UK corporate bond funds are widely available. There are easily over 100 on offer holding over £37 billion of investors' money. Many bond funds mix gilts and corporate bonds together and may invest in both the investment grade and high yield types. This could make for a more balanced investment, providing exposure to different types of debt and risk. Should You Invest In A Corporate Bond Fund? Demand for bonds is high when interest rates and inflation are low because the fixed income return is more desirable to investors. Your opinion on where interest rates will head over the term of your investment should influence your decision, but it looks like there may be more interest rate cuts this year so yields may be attractive in the short-term at least. What's more, the credit crunch has caused professional investors to offload even high quality bonds just as it has discouraged banks from lending to one another. This has trimmed back bond prices which could also be an excellent opportunity to take advantage of a higher yield. Bonds allow companies to raise funds without the need to issue new shares. If shares are too volatile for your liking, a corporate bond fund will allow you to lend to a company without the added risk of actually investing in it. After all, when it comes to repaying debts bondholders rank ahead of shareholders who are stuck at the back of the creditor queue if a company goes bust. That said, if you invest in a corporate bond fund, there's also a risk that the fund manager will buy the wrong bonds. On a final note, if you think corporate bonds are for you, then my advice would be go for a fund that can offer both reasonable charges and an excellent track record in relation to its peers. You could look at performance figures on Trustnet. *- Figures as at 4th February, 2008. More: How To Shelter From Sliding Shares | Steer Clear Of Stock Market Storms | Don't forget both gilt and corporate bonds funds can often be held in an ISA where you'll earn a tax-free return.