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How do corporate bonds work?

As the world's stock markets continue to show signs of volatility, manyinvestors over the last 6 months have started to look at good qualitycorporate bonds for a certain percentage of their portfolio.

As the world's stock markets continue to show signs of volatility over the last 6 months, many investors have started to look at good quality corporate bonds for a certain percentage of their portfolio. Good quality bonds (investment grade; rated BBB and higher) tend to have very low default rates (less than 1%) but pay higher than government bonds at this time. With shorter term (less than 5 years) government bonds paying only 2% to 3%, it doesn’t make sense to be a buyer. However it is possible even with the prevailing low interest rate environment that an investor can still make between 4% and 5% on low risk investment grade corporate bonds.

Most corporate bonds (or debentures) tend to look the same when you buy them. They have a coupon rate, which is the annual rate of interest the bond pays to the holder of that bond and a price at which the bond is offered. Each bond is priced at $100 when it is first issued. Each day, interest rates change and thus the price of the bond changes with it. The price of bonds tends to rise when interest rates fall and fall when interest rates rise. One of the most common misconceptions when buying bonds is that an individual believes the coupon interest rate (the annual rate) is the same as their overall rate of return. This is only the case when the purchase price of the bond is $100. If interest rates fall and the price was to rise from $100 to $102, this would mean that for every $100 of the bond an investor is going to purchase, it would cost that investor $102 to purchase it. Thus a bond for $10,000 would cost $10,200. This slight purchase premium effectively lowers the overall rate of return on the bond because the investor has to pay an extra $200 upfront. So even if the bond is paying a 5% annual coupon (interest) rate, the rate of return would be less than 5% due to the extra $200 the investor has to pay upfront.

When an investor buys a bond, there is also a small calculation for accrued interest that gets added to the cost of the bond. Accrued interest is the amount of interest owed to the previous owner that you are purchasing the bond from. Bonds pay interest for the most part every 6 months and, because bonds can be purchased on any day, there has to be a calculation which accounts for the interest owed to the previous owner. Therefore if an investor was to purchase a bond 3 months after the most recent interest payment on that bond, the new owner would have to pay the previous owner 3 months worth of interest up front (because the new owner did not own the bond for the full 6 month period). Then at the end of 6 months, when the bond pays out the full amount of interest, the new owner would receive 6 months worth of interest. The new owner would receive 6 months worth of interest but paid 3 months worth to the previous owner leaving him with 3 months worth of interest which is rightfully his. Accrued interest is only paid once at the time of purchasing a bond unless a bond is purchased right on the 6 month date.

Bonds in general are a crucial part of any balanced portfolio. Investors tend to use bonds as the low risk part of their portfolio although there are bonds that are medium and high risk as well. The risk rating depends on the credit worthiness of the institution issuing the bond. This is why government bonds have the highest rating. However they also tend to pay the least amount of interest. With interest rates so low at this time, corporate bonds tend to make more sense that government bonds. An investor can purchase good quality corporate bonds that are low risk and make a few percentage points higher than if they purchased a government bond. For this reason, the corporate bond market today is quite tight with very little inventory available to retail investors. Everyone is trying to buy corporate bonds and there are not enough companies issuing bonds at this time. Thus the rates of return on the bonds that are available are quite low. However, if an investor is patient, bonds will become available on an ongoing basis.

If you have any questions regarding the above article or today’s bond opportunities please send me an email at asmall@dundeesecurities.com. I will be happy to speak to you!

– Allan Small is an Investment Advisor with Dundee Securities Corporation, a DundeeWealth Inc. Company. This is not an official publication of Dundee Securities and the author is not a Dundee Securities analyst. The views expressed are those of the author alone, and are not necessarily those of Dundee Securities

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