10% Return and Capital Protected Bond — Too Good to be True? (3 Pitfalls to Note When Investing Corporate Bond)
Most people thought that bond is the boring instrument offered by the Government for 2% return, which does not sound attractive at all.
What about a bond that is capital protected and offer 7% return? Would that be of interest?
Of course, it comes with ‘greater’ risk but if we know how to choose and diversify, we can lower the risk.
Introducing corporate bonds
What I am talking about is corporate bonds.
Corporate bonds is a bond issued by a corporation to raise financing for a variety of reasons such as to ongoing operations, M&A, or expanded business. Terms for corporate bonds can be anywhere from less than 5 years to more than 12 years.
When you invest in corporate bonds, you are essentially making a loan to the company, rather than getting an ownership stake, which you get through shares. So corporate bonds would appear in the liability column of the company’s financial statements (and asset column in your statements).
Corporate bonds usually have a face value of $100 when issued. That amount is repaid upon the ‘maturity date’ when the bond expires. In order words, it is capital protected*.
№1 pitfalls: risk of liquidation
The reason why there is an asterisk after capital protected is because any promise is as good as the guarantor.
Having said that, if the company liquidates, the bond holders usually have priority over stockholders in a company’s capital structure and are more likely to receive payment. If we can accept the liquidation risk in buying stocks (which has a lower repayment priority than bonds), then this risk should be acceptable to us.
Still, we can reduce this risk by referring to the credit rations of that particular corporate bond. Credit ratings are very important metrics of a bond’s quality and riskiness. A corporate’s balance sheet, profit outlook, competition, external and internal factors all come into play in computing a credit rating.
Corporate bonds are rated by services such as Standard & Poor’s, Moody’s, and Fitch, which calculate the risk inherent in each specific bond. Higher rated bonds, known as investment-grade bonds (from “AAA” to “BBB-“) , are seen as safer and more stable investments that are tied to corporations or government entities that have a positive outlook.
Non-investment grade bonds or so-called “junk bonds” usually carry ratings of “BB+” to “D” are seen as higher risk investments but they often provide a higher return in compensation for the risk.
I had a bad experience of investing a BB+ bond (“junk bond”) with 10% interest. 10% is really attractive and it looked like a decent up and running property company, so I invested $500,000 into it. It went into liquidation 4 months later, and there is no assets left even for bondholders as the property is half-finished.
It is not to say that investment grade bonds would not liquidate though because there is always risk but the risk is lower.
№2 pitfall: risk of early redemption
Redemption of bonds payable refers to the buy-back of bonds by their issuer (i.e. the corporation who issued the bonds).
This usually occurs at the maturity date of the bonds, but may occur earlier if the bonds contain a call feature (you have to look at the prospectus to find out). If the bond prospectus allows for early redemption, the issuer can redeem the bonds early in order to take advantage of a decline in the market interest rate.
When a bond issuer redeems a bond, we receive the face value of the bond and any interest that has accrued since the last time an interest payment was made. In order words, early redemption means we are losing out on some of the interests that we expect when buying the bonds.
If we bought the bonds at a premium, thinking to cover that premium with say 3 months of interest and after the 4th month the corporation calls for early redemption of the bonds, you could end up with no or little (or even negative) return on investment.
№3 pitfalls: bond prices volatility
Disregarding the interest for a moment, there is risk that you may buy corporate bonds at its high price and sell when its prices fall, hence there is still the risk of volatility (same as if you invest in stocks).
There are many factors that may cause the bond prices to fall e.g. changes in the corporation’s financial health, time until maturity (as a bond gets closer to its maturity date, the bond’s price approaches par value), change of the bond’s credit rating, prevailing interest rates (when bank saving’s interest is reduced, corporate bonds become a more popular investment and due to increased demand, the prices may rise) etc.
Note: this is not investment advice. Please be reminded to do your own research and consider your own circumstances before making any financial decisions.
