If you’re new to corporate bonds, it’s worth digging deeper to understand the mechanics. An easy place to start is with this question:

What are bonds?

Companies usually borrow money in one of two ways. They can borrow from banks, or they can borrow from the market by issuing bonds. Bonds are basically IOUs: they are typically bought by institutional investors, who may then trade them with other investors.

If you buy and hold a bond to maturity – the returns to investors are driven by two main factors.

1. The face value that is paid when the bond matures

2. The steady stream of income called the coupon.

Corporate bonds are very different to shares. Shares are the ownership of a small portion of a company, while corporate bonds are essentially a loan to the company.

What sets one corporate bond apart from another?

Corporate bonds are not all the same. This is mainly because the companies that issue them vary markedly in terms of their financial strength. The financial strength of a company depends on many things, such as the health of the industry it’s in, the strength of its own business and the amount of money they have borrowed etc. Two companies that are broadly similar by many measures can be very different in terms of financial risk. However, the bond that is issued by the riskier company is not necessarily a less attractive investment – if it offers a suitably attractive return.

At a basic structural level, corporate bonds differ in three key ways:

1. Face value

This is the nominal value of the bond, which the company promises to pay when the bond matures. It may be $10,000 or $100,000 or any value set by the issuer at the time of issue. The market value (or price) of the bond can be higher than the face value or lower once trading begins The main driver of fluctuations in price is interest rates, which we discuss later.

2. Coupons

The coupon is the annual income paid to investors and expressed as a percentage of the face value, the coupon rate. The word coupon reflects the fact that when bonds first existed in physical paper form, they would normally have coupons attached. To be paid, the investor would detach the coupon for a particular payment and take it to the company’s bank. Coupons are the equivalent of dividends for shares, except that the bond issuer is 100 per cent obliged to pay the coupon, or it will be in default.

Coupons are usually paid quarterly or semi-annually, on specified dates. If a bond with a face value of $100 has a coupon of 5 per cent, paid semi-annually, there will be two payments of $2.50 per year. Coupons can be either fixed or floating. The 5 per cent coupon above is a fixed coupon, and these are paid six-monthly in Australia.

A floating coupon is usually expressed as a set amount above a floating benchmark. The most common floating benchmark in Australia is called ‘BBSW’, or the three-month bank bill swap rate – a rate used for inter-bank transactions. A floating coupon rate might be BBSW + 0.80 per cent. If BBSW was 2.2 per cent on the rate-setting day, then the next coupon would be 3.0 per cent. Floating rate coupons are generally paid quarterly. BBSW moves up and down with interest rate expectations and actual rate changes the RBA makes.

3. Term to maturity

Different bonds will also have different terms to maturity (also called the tenor). This is the period to the maturity date – the date the face value and the final coupon are paid to investors. Of course, an investor does not have to hold a bond to maturity; they may sell it in the market, subject to liquidity, at the prevailing bond price.

How interest rates affect corporate bonds

Investors may be aware that bond values are sensitive to interest rate expectations and changes in the cash rate. When people say this, they’re talking about fixed coupon bonds.

All fixed rate bonds are sensitive to interest rates changes and expectations of change. How sensitive they are depends on a number of factors, including the term to maturity.

Floating rate bonds are not as sensitive to interest rate expectations. Floating rate bonds issued at $100 will mature at $100, and usually trade in a tight band around that level. Most ‘floaters’ are issued by banks, which means the credit risk (risk you don’t get paid) is lower than many other corporates, because of the prudential supervision of Australian banks by APRA. This further reduces their price volatility.

What is yield?

Yield is the return an investor receives it they buy a bond and hold it until maturity. It is based on the purchase price and assumes that all coupons can be reinvested at the same yield.

What are the benefits that corporate bonds bring to SMSFs?

Corporate bonds are defensive. This means they generally don’t follow shares down, so they can act to defend your portfolio. Equities and hybrids tend to move together and are a lot more volatile than corporate bonds

The capital stability of corporate bonds can anchor your portfolio in a similar way to government bonds or Term Deposits (TDs). In addition, they can give you extra yield compared to both government bonds and TDs for the added risk a corporate loan represents over a loan to the government or a bank deposit.

But aren’t corporate bonds the domain of institutional investors only?

Traditionally, corporate bonds have been traded between institutional investors in large parcels of $500,000 – which is too large for most SMSFs. Corporate bonds generally trade over-the-counter and not on the ASX, making them hard to access.

A recent, significant change is that SMSFs can now access the returns from corporate bonds through XTBs (Exchange-Traded Bond units), which are available on the ASX. XTBs can be bought in parcels as small as $100.

An XTB gives investors access to the returns from individual bonds, issued by some of Australia’s largest companies. Each XTB matches the characteristics of a particular bond. For example, if a Telstra bond matures in five years’ time, then so will the Telstra XTB based on that bond. All of the coupons and principal from the underlying bond are passed back to the XTB investors.

The fee for the XTB is built into the price you pay when buying it. The impact of this is to reduce the yield available on the bond in the wholesale market by about 0.4 per cent. For example, a bond trading at a yield of 4.6 per cent in the wholesale market will be approximately a 4.2 per cent yielding XTB on the ASX. Floating rate XTBs have a lower fee at 0.2 per cent.

Predictable income and better returns can be available

Corporate bonds and XTBs provide steady and predictable income with yields that can be in the region of 1 per cent to 1.5 per cent better than a TD (for the added risk). If your income is 2.8 per cent from a nest egg in TDs, then 4 per cent from fixed coupon XTBs is 1.2 per cent better in absolute terms. Importantly, this would relate to an increase in your income of about 40 per cent. The predictability of the income also means that forward-looking cash flow planning is easier, because once you own the bond or XTB over it, you know what to expect, and when you will get it.

XTBs can be bought or sold on the ASX just as you would shares, ETFs or Listed Investment Companies. XTBs have two Market Makers. The Market Maker provides the buying and selling opportunities for XTB investors in exactly the same way Market Makers do for ETFs and other similar investment products on the ASX. Their ability to do this is only limited by the available liquidity in the market for the underlying bonds (trading in the wholesale bond market).

Key considerations

Like all investments, corporate bonds also have some risks. The main considerations are:

• Credit risk – the risk that the corporate may not pay back the loan and/or default on coupon payments.

• Liquidity risk – Particular corporate bonds may, from time to time, be difficult to sell except at a significant discount to the current market price or the face value.

• Inflation risk – If there is a change in inflation expectations, interest rates are also likely to change. If the expectation is for higher rates of inflation, the market yields of bonds are generally expected to rise and the market prices of bonds are generally expected to fall.

• Currency risk - If you hold an investment that is denominated in a foreign currency, the value of that investment in Australian dollar terms is likely to fall if the Australian dollar rises.

Richard Murphy, chief executive and co-founder, Australian Corporate Bond Company.