How to beat low savings rates
If you don't fancy taking your chances on the stock market, and low rates on savings don't appeal either, could corporate bonds be the answer?
If you've got a chunk of cash held in ordinary savings accounts, I wouldn't blame you for having a good old grumble about today's appalling interest rates.
At the same time, you may also have decided to keep your distance from the turbulent stock market with the economic crisis wreaking havoc on share prices.
Unfortunately, this means the chances of getting a decent return on your cash are becoming increasingly slim. So, when savings accounts and shares generally aren't up to the job, what can you try next? Well, one option is to invest some money in corporate bonds.
What are corporate bonds?
Put simply, a corporate bond is a loan to a company which pays a fixed rate of interest for a set period. Companies issue bonds to investors as a way of raising extra capital to plough into their businesses.
Bonds can be traded, which means it's possible to make a capital gain if the bond is sold at a higher price than the price it was bought for. But the reverse is also true, so there's a chance you could make a capital loss.
In practice, bonds aren't usually bought by individual investors. Instead, professional fund managers buy a portfolio of bonds held in a corporate bond fund. Ordinary investors (like us) can then pool their money into the fund. The idea is that the fund manager will trade the bonds in the portfolio with the aim of maximising the return for investors.
Income from the fund can be paid out to investors if required. But, if you're after capital growth, income can be re-invested back in the fund instead.
Remember that while the interest paid on one company's bonds is fixed, the income you'll receive from a bond fund is variable. This is because the fund consists of a selection of bonds, each with their own interest rate and maturity date. The income will also fluctuate as the bonds are bought and sold.
How risky are corporate bonds?
On the risk spectrum, bonds are considered halfway between near risk-free cash and more risky shares.
In other words, while bond prices aren't as volatile as share prices, there is still a significant risk of capital loss if bond prices fall. Similarly, you could potentially get a better return than a high street savings account could offer.
So, what influences prices?
Several factors come into play here. Bond prices are affected by sentiment towards interest rates, inflation and the well-being of the economy.
If interest rates are expected to rise in the medium to long-term, the value of your corporate bond investment is likely to fall. Similarly, if rates look likely to fall, the value will rise.
Company performance, and therefore the default risk, also has a huge impact on bond prices. The default risk is the probability the company won't be able to pay back the capital borrowed from the investor at the bond's maturity date. If a company has been struggling and its default risk rises, the bond price is likely to be pushed down.
Bond ratings
Bonds are rated so that investors know how creditworthy the companies issuing them are. They generally fall into two categories: investment grade bonds and high yield bonds - also known as 'junk' bonds.
Investment grade bonds are deemed to be better quality with a lower default risk, while high yield bonds are more risky. To compensate the investor for taking on this extra risk, high yield bonds do exactly what they say on the tin by rewarding the investor with a higher yield. Meanwhile investment grade bonds pay comparatively lower yields.
Remember, that ratings can change as companies are regularly reassessed. If the outlook for a company improves, its credit rating may go up, and vice versa.
Corporate bond fund managers can invest solely in one type of bond or mix the two together to diversify your investment. If you're going to take the plunge, make sure you check the quality of the bonds first.
Are corporate bonds a good bet now?
This year, corporate bonds are certainly growing more popular again as many investors have little appetite for cash or shares. And there's no question they have the potential to generate far better returns than savings accounts.
That said, performance can be volatile. According to financial data website, Trustnet, the average corporate bond fund has returned 6.5% so far this year. However, in 2008, average returns were -9.2%. So you can see how quickly fortunes change.
Of course, some funds will perform significantly better than average, while others will do a lot worse. Make sure you check the track record of a fund and its manager before you invest. Quite simply, if the manager makes poor decisions and invests in the wrong bonds, the returns will suffer. You can compare past performance at Trustnet. (But don't forget that past performance doesn't mean you can know how funds will do in the future.)
I want to emphasise here that if you're risk-averse and you want your cash to be secure, then corporate bonds are not the answer.
Corporate bond ISAs
Finally, if bonds have captured your attention, and you haven't yet used your ISA allowance, you'll be pleased to know many funds can be put in an ISA wrapper. The favourable tax treatment of ISAs will then boost your returns.
Well-known fund management groups such as Fidelity, Legal & General and Invesco Perpetual have sold corporate bond ISAs for years, so it's well-worth checking them out if you are interested in making your first move into corporate bond savings.
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