Corporate bond prices are highly susceptible to changes in interest rates. When interest rates rise, new bond issues come to the market with higher yields than older bonds, making those older ones worth less. Hence, their price goes down. Conversely, when interest rates decline, new bond issues come to the market with lower yields than older bonds, making those older, higher yielding ones worth more. Hence their price goes up.
Corporate bonds are also vulnerable to inflationary pressures. The interest rate paid to bondholders is fixed at a rate determined on issue. Consequently, if inflation rises, the “income” received from the bond actually becomes worth less, as goods and services become more expensive. Inflation is one of the most influential forces on interest rates. Rising inflation often leads to rising interest rates, which reduce bond prices. Conversely, deflation would result in a lowering of interest rates, which would increase the price of bonds.
The length of time to maturity has a bearing on the yield. This is because over a longer period of time, corporate bonds are at more risk of being subject to inflation or interest rate rises. In addition, over a long term, there is increased risk that a company’s financial strength can deteriorate. These factors mean that investors will demand a higher yield to reflect the additional risks.
Whilst corporate bonds are associated with cautious investment strategies, there are risk factors in addition to the inflation and interest rate risks outlined above to which bonds are subjected which need to be understood by the investor. Corporate Bonds are subject to credit risk which means that losses can result following a deterioration in the financial health of the issuing company. Bonds rated with a credit quality of “BBB” or above by Standard & Poor’s are widely regarded as “investment grade”. Higher risk corporate bonds are rated “BB” or lower and are considered to be “non-investment grade” bonds which carry a higher “default risk” where the issuing company fails to meet payment of the bond’s coupon or cannot repay the bond’s face value at maturity. Hence there is a spectrum of risk within the corporate bond sector with better rewards, but higher risk with bonds with lower credit ratings.
The complexities of yields and credit ratings can detract from the benefits which investing in bonds can bring to any well diversified investment portfolio. Bonds can provide a “hedge” against equity underperformance. This is because bond returns are not highly correlated with those of equities. Hence, if equity prices fall, bonds will not always follow suit. As such, when combined with other investment vehicles, they can be a useful diversification tool.