Before you readCapital at risk. The value of investments and any income from them can fall as well as rise, and you may get back less than you invest. This is information, not advice.
In one paragraphCompanies borrow from investors by selling bonds, just as governments do. They usually pay more interest than the government, because the risk of not being repaid is higher. How much more depends on how strong the company is, and a credit rating is the usual shorthand for that.
A company that needs money for a new factory, new technology or to refinance old debts has three main choices. It can borrow from a bank, sell new shares, or borrow from investors by selling bonds. Selling bonds lets it borrow large amounts for a long time without giving away any ownership.
Why does a company pay more than the government?
Because a company can fail, and lenders want to be paid for that risk. The extra interest a company pays over a government bond of a similar length is called the spread.
| Government bond, five years | 4% |
|---|---|
| Company bond, five years | 6% |
| Spread | 2 percentage points |
Spreads widen when lenders become more worried about companies in general, and narrow when they are more relaxed. That is why corporate bond prices can fall even when a particular company is doing fine.
What does a credit rating tell you?
Independent agencies, the most widely used being Standard & Poor's, Moody's and Fitch, study a borrower and give it a grade. A rating is an opinion, not a promise. It can be raised if a borrower's position improves, or cut if it gets worse, and a cut usually lowers the price of that borrower's bonds.
| S&P and Fitch | Moody's | What it means |
|---|---|---|
| AAA | Aaa | The strongest borrowers |
| AA | Aa | Very strong |
| A | A | Strong |
| BBB | Baa | Adequate. The lowest investment-grade band |
| BB | Ba | High yield: more exposed to bad times |
| B | B | High yield: vulnerable |
| CCC to C | Caa to C | High yield: at real risk of not paying |
| D | C | Has already failed to pay |
What is the difference between investment grade and high yield?
Investment grade covers borrowers rated BBB- (or Baa3 at Moody's) and above. They are usually large, established companies with strong finances, so they do not need to offer as much interest to attract lenders.
High yield, also called non-investment grade or speculative grade, covers everyone below that line. These companies pay more interest because lending to them is more likely to go wrong. Newer or less established companies often start here. Higher income is payment for higher risk, not a free extra.
What happens if a company fails?
If a company cannot pay, it has defaulted. Its lenders are paid before its shareholders from whatever is left, so bondholders often get some of their money back. How much depends on the company and on where the bond ranks. Senior bonds are paid before subordinated ones. Some lenders get back most of their money, and some get very little.
A bond also comes with covenants: legal promises the company makes to its lenders. At the very least, it promises to pay the interest and repay the loan. Some covenants go further, for example limiting how much more the company can borrow.
What is a callable bond?
Some bonds let the company repay early, on set dates. Companies usually do this when interest rates have fallen and they can borrow more cheaply elsewhere. You get your money back, but the interest stops sooner than you planned, and you may only be able to lend it again at a lower rate. In the £1,000 example, a bond repaid at the end of year three instead of year five pays £1,150 in all, not £1,250: the last two £50 payments never arrive.
What are securitised bonds?
Some bonds are not a loan to one company at all. They are backed by a large pool of other loans, such as mortgages, car loans or credit card debts, bundled together. The interest you receive comes from the payments on those loans.
- Mortgage-backed securities are backed by home or commercial mortgages.
- Asset-backed securities are backed by consumer loans or leases.
- Collateralised loan obligations are backed by loans to companies.
They can pay more than similar bonds, but they are harder to understand. Many people who want high yield or securitised bonds hold them through a fund instead, which chapter VI explains.
Their value depends on how the underlying loans perform, and on how the bond itself is put together.
Whatever the borrower, the whole market also moves with interest rates and inflation, which chapter VII covers. Every bond has a coupon, a price and a yield. The next chapter shows how those three connect.