Investing in credit and the role of corporate bonds

By Vanguard

Investing strategy

 

How the global bond market offers stability and income potential

It might come as a surprise to you that, at an estimated total value of US$130 trillion, the global bond market is actually bigger than the US$110 trillion combined total value of all publicly traded companies worldwide.

Bonds – the primary credit borrowing vehicles for governments and many companies – are a massive component of global financial markets.

And investors worldwide have been flocking to bonds in recent times to take advantage of interest rate returns and to offset their exposures to more volatile equity markets.

In this article, Sarang Kulkarni, Lead Portfolio Manager, Vanguard Global Credit Bond Fund, discusses credit and the global credit sector, investing in corporate bonds, and the current bond market outlook as interest rates continue to fall.

 

What do we actually mean when talk about credit?

Kulkarni: Credit is a generic term for a loan. People know about credit cards, which are basically a bank’s way of making short-term loans to individuals in small sizes. It’s the same kind of concept that you have for companies and governments. The difference between a credit card loan and a credit loan in the bond market is that the terms of those loans are set in advance and they don’t change over the life of that loan. And, unlike a credit card loan where the bank would really like you to pay it off as soon as you can, some of these companies can issue bonds for 30 or 50 years. Companies take the money and use it to do what they need to do to run their business. Bonds issued by companies and governments can be freely traded. When an investor is getting into the credit area, basically they’re providing the money for the loan and they then receive a return for taking on that risk.

 

What are the risks with credit investments?

Kulkarni: All lenders like to know that they will ultimately get their money back from the borrower. In the case of lending money to governments there’s a good amount of certainty investors will get their money back. It’s the same with lending money to very big companies. But as you start dealing with smaller companies or companies that are in more riskier businesses, then there’s actually no guarantee that they’re going to be able to return your money. If you translate that to interest rates, basically where you have more guarantee that you’d get your money back, you charge them a lower interest rate, and when you’ve got less guarantee, you charge them a higher interest rate. It’s the same as when you buy a house. If you’re putting an 80% deposit down on your house, you get a lower interest rate than if you put down a 20% deposit. And so that’s the credit risk.

 

What role can corporate bonds play in a portfolio?

Kulkarni: There are typically four big needs that people look for when they buy corporate bonds. The first one is liquidity. This is the world’s biggest financial market, so it’s very easy to make investments and it’s very easy to withdraw those investments. So whenever you need your money back, most corporate bond funds are set up to give you money back whenever you ask for it. The second big role is income. For a long period of time interest rates were very low and bond yields were very low, so the capability of bonds to generate income was limited. But that has changed quite dramatically to the point where the income generating potential from corporate bonds is much higher than that of equities. The third thing is returns. Income forms a big part of the total return that you get from corporate bonds, but corporate bonds also respond to changes that are happening in the general financial marketplace. And finally, the biggest attraction of bonds is that generally bonds go up in price when equities go down in price, although that’s not always the case. That’s why having a 60/40 portfolio is so popular. While capital appreciation comes from your 60% in equities, you also know that you’ve got some capital preservation from the 40% of your portfolio invested in fixed income.

 

What is the current outlook for fixed income?

Kulkarni: It’s interesting to think about what has happened in the last few years. When interest rates were going up, in a way you were much better off holding things like cash and cash-like products because the interest on them rises as interest rates go up. But now we’re in an environment where interest rates are expected to go down, cash deposits and cash-like products are going to be making less income every time the RBA cuts rates. On the other hand, a corporate bond will typically go up in price as the RBA cuts interest rates. So, instead of losing income, you could gain from owning corporate bonds. For retail investors, you’ve got to be mindful of what phase of the market you’re in, and I think we’re in a pretty good phase of the market for corporate bonds.