This article was taken from the December 2023 issue of Market Insight. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications
Much has been written regarding the renewed interest in corporate bonds. Here we revisit some of the basics of corporate bonds.
In its simplest form, a corporate bond is a debt instrument issued by a company to raise funds. Three key items to know are the bond’s face value, coupon, and maturity date. The face value is the monetary value of the bond when issued, usually £100, which is repaid to the investor when the bond matures. The coupon is the return offered to the investor throughout the life of the bond, given as a percentage, it tells the investor just how much income is to be paid out. A bond with a coupon of 6% and face value of £100 will pay out an income of £6 each year until the bond matures, at which point the investor receives the final coupon and the face value, £106 in this case. Finally, the maturity date gives the life of the bond, a bond issued today with a maturity date in 2028, has a life of five years. As such, anyone buying that bond when it was initially sold to the market, at T=0, can expect to receive the income from the coupons and their initial value back at the maturity date.
| Time (T = Year) |
T=0 |
T=1 |
T=2 |
T=3 |
T=4 |
T=5 |
| Cashflow (£) |
-100 |
6 |
6 |
6 |
6 |
106 |
The level of coupon assigned to the bond is decided before the instrument is issued and is comprised of two parts. The first involves matching the corporate bond to a government bond of a similar maturity date. Using the example above, if the 2028 UK government bond is currently yielding 4% then this will form the starting point of the coupon. Given we are lending to a company, investors require extra compensation, or ‘spread,’ for the risk taken. This spread is decided by several factors, but mostly reflects the creditworthiness of the issuer. Assuming investors require an extra 2% of return, the combination of this spread with the government bond yield mentioned above results in a bond coupon of 6%.
Once issued, the market value of the bond will fluctuate around its face value given changing market conditions. Due to having fixed payments, the market value is most sensitive to movements in the yields of government bonds, but this level of sensitivity, or duration, declines the closer the bond gets to its final maturity date. Bonds with lots of sensitivity to government bond yields are ‘long duration’ and will have longer periods of time till they reach their final maturity date. Those with less sensitivity are ‘short duration’ and expected to mature in the non-too distant future. This is driven by the fact that provided the issuer of the bond is expected to pay back the debt, the bond will always trend back towards its face value as it approaches maturity in what we call ‘pulling-to-par.’
Thinking back to the composition of the return, a bond’s price will also have sensitivity to the level of spread investors require. If the probability of the company paying back the money at maturity is declining, investors will demand more compensation. As a result, the bond’s price will decline to reflect this with the sensitivity known as ‘spread duration.’ This can work in the opposite direction, with the spread demanded declining in favourable economic conditions, pushing the price higher with investors willing to accept less compensation.
Having broken down the two return components of a corporate bond, it is important to remember that the two sensitivities can work in tandem and against each other to cause the bond’s price to fluctuate around the face values. In March 2020 for example, concerns around the pandemic caused a significant move higher in credit spread, while government bond yields fell as central banks flooded the system with cheap money. Corporate bond markets initially sold-off sharply but recovered as both government bond yields and credit spreads moved to all-time lows.
Given the market price of bonds can fluctuate around the face value, we need to introduce another measure in bond pricing, the yield-to-maturity. This is the yield on offer through a combination of income and the price movement back to face value at maturity. If a 6% coupon bond is issued at a face value of £100, the yield-to-maturity issuance is 6%. If the bond trades below the face value, then the investor can benefit from some capital return when the bond matures along with the coupon income, resulting in a yield-to-maturity above the 6% mark. The yield-to-maturity is a useful guide to the potential return on offer if the intent is to hold until maturity. A pitfall comes in the assumption of coupons being reinvested at the current yield, a figure constantly changing with market fluctuations and as such it is not a guarantee but a useful guide.
Having been through an extended period of low yields in the corporate bond market, higher government bond yields and greater compensation via the credit spread has returned corporate bond yields to levels not seen since the financial crisis. With the yield-to-maturity on the sterling corporate bond reference index trading around the 6% mark, it is easy to see why there’s renewed interest in this recently unloved area of the market.
Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. Investments and income arising from them can fall as well as rise in value. Past performance and forecasts are not reliable indicators of future results and performance.