UNDERSTANDING INVESTING Corporate Bonds After government bonds, the corporate bond market is the largest section of the global bond universe. With a vast array of maturities, yields and credit quality available, investing in corporate bonds has the potential to provide higher yields than government bonds and diversification benefits for investors. WHAT ARE CORPORATE BONDS? Speculative-grade bonds are issued by companies perceived to have a lower level of credit quality compared to more highly When companies want to expand operations or fund new rated, investment-grade, companies. The investment-grade business ventures, they often turn to the corporate bond category has four rating grades while the speculative-grade market to borrow money. A company determines how much category is comprised of six rating grades. it would like to borrow and then issues a bond offering in that amount; investors that buy a bond are effectively lending money to the company according to the terms established in STANDARD MOODY’S & POORS the bond offering or prospectus. INVESTMENT GRADE Unlike equities, ownership of corporate bonds does not signify an ownership interest in the company that has issued the Highest quality (Best quality, smallest degree of Aaa AAA bond. Instead, the company pays the investor a rate of interest investment risk) over a period of time and repays the principal at the maturity High Quality Aa AA date established at the time of the bond’s issue. (Often called high-grade bonds) While some corporate bonds have redemption or call features Upper medium grade A A that can affect the maturity date, most are loosely categorized (Many favourite investment attributes) into the following maturity ranges: Medium grade • Short-term notes (with maturities of up to five years) (Neither highly protected nor poorly Baa BBB secured) • Medium-term notes (with maturities ranging between five and 12 years) SPECULATIVE GRADE Somewhat speculative • Long-term bonds (with maturities greater than 12 years) Ba BB (Have speculative elements) In addition to maturity, corporate bonds are also categorized Speculative by credit quality. Credit rating agencies such as Moody’s (Generally lack characteristics of a B B Investors Service and Standard & Poor’s provide independent desirable investment) analysis of corporate bond issuers, grading each issuer Highly speculative Caa CC according to its creditworthiness. Corporate bond issuers with (Bonds of poor standing) lower credit ratings tend to pay higher interest rates on their Most speculative Ca CC corporate bonds. (Poor prospects) Imminent default C C HOW ARE CORPORATE BONDS RATED? (Extremely poor prospects) The corporate dividing line: investment-grade and Default C D speculative-grade. Corporate bonds fall into two broad credit classifications: investment-grade and speculative-grade (or high yield) bonds. 2 Corporate Bonds Historically, speculative-grade bonds were issued by companies yields than government bonds of similar maturities. This that were newer, were in a particularly competitive or volatile divergence creates a credit spread between corporates and sector or had troubling fundamentals. Today, there are also government bonds, so that the corporate bond investor earns many companies whose businesses are designed to operate extra yield by taking on greater risk. The credit spread affects with the degree of leverage traditionally associated with the price of the bond and can be graphically plotted and speculative-grade companies. While a speculative-grade measured as the difference between the yield of a corporate and credit rating indicates a higher default probability, these government bond at each point of maturity. bonds typically compensate investors for the higher risk by paying higher interest rates, or yields. Credit ratings can be CREDIT SPREADS downgraded if the credit quality of the issuer deteriorates or upgraded if fundamentals improve. YIELD% Fallen angels, rising stars and split ratings “Fallen angel” is a term that describes an investment-grade AA- US corporated bond company that has fallen on hard times and has subsequently had its debt downgraded to speculative grade. “Rising star” credit spread refers to a company whose bond rating has been increased by a credit rating agency due to an improvement in the credit US Treasury bond quality of the issuer. Since the credit rating agencies’ ratings are subjective, there are also times when they do not concur on the MATURITY rating – an occurrence known as a “split rating.” Fallen angels, rising stars and split ratings may all present opportunities for HYPOTHETICAL EXAMPLE FOR ILLUSTRATIVE PURPOSES ONLY investors to add additional yield by assuming greater risk due to the potential volatility of their ratings. WHY INVEST IN CORPORATE BONDS? Corporate bonds can offer a range of potential HOW ARE CORPORATE BONDS PRICED? benefits including: The price of a corporate bond is influenced by several factors, • Diversification: Corporates offer the opportunity to invest including maturity, the credit rating of the company issuing in a variety of economic sectors. Within the broad spectrum the bond, and the general level of interest rates. The yield of of corporates there is a wide divergence of risk and yield. a corporate bond fluctuates to reflect changes in the price of Corporate bonds can add diversification to an equity the bond caused by shifts in interest rates and the markets’ portfolio as well as diversify a fixed income portfolio of perception of the issuer’s credit quality. Most corporate bonds government bonds or other fixed income securities. (or, corporates) typically have more credit risk and higher Corporate Bonds 3 • Income: Corporates have the potential to provide attractive income. Most corporate bonds pay on a fixed, GLOSSARY semiannual schedule. One exception is zero-coupon bonds, which do not pay interest but are sold at a deep Coupon: The interest payments a bondholder receives until the bond matures. discount and then redeemed for full face value at maturity. Another exception is floating-rate bonds that Corporate bond: Debt instrument issued by a company, have fluctuating interest rates tied to a money market distinct from one issued by a government or government agency. reference rate such as the London Interbank Offered Rate (LIBOR) or federal funds rate. These tend to have lower Credit risk: The risk of loss of principal or loss of coupon yields than fixed-rate securities of comparable maturities payments stemming from a borrower’s failure to repay a loan but also less fluctuation in principal value. or otherwise meet a contractual obligation. • Higher yields: Corporates tend to provide higher yields than Credit spread: The yield differential between a corporate comparable maturity government bonds. bond and an equivalent maturity sovereign bond. For example, if the 10-year Treasury note is trading at a yield of 2% and a • Liquidity: Corporate bonds can be sold at any time prior to 10-year corporate bond is trading at a yield of 4%, the credit maturity in a large and active secondary trading market. spread is 2% or 200bps. WHAT ARE THE RISKS? Fallen angel: An investment-grade company that has subsequently had its debt downgraded to speculative grade. Similar to government bonds, corporate bonds are exposed to interest rate risk. In addition, corporate bonds also have Interest rate risk: When interest rates rise, the market value credit or default risk - the risk that the borrower fails to repay of fixed-income securities (such as bonds) declines. Similarly, when interest rates decline, the market value of fixed-income the loan and defaults on its obligation. The level of default risk securities increases. varies based on the underlying credit quality of the issuer. Maturity: The number of years left until a bond repays its principal to investors. Rising star: A company whose bond rating has been increased by a credit rating agency due to an improvement in credit quality. Yield: The income return or interest received from a bond. IMPORTANT DISCLOSURES Newport Beach Headquarters Past performance is not a guarantee or a reliable indicator of future results. 650 Newport Center Drive Newport Beach, CA 92660 The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. +1 949.720.6000 The quality ratings of individual issues/issuers are provided to indicate the credit-worthiness of such issues/issuer and generally range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody’s, and Fitch respectively. A word about risk: Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and Hong Kong bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond London counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Corporate debt securities are subject to the risk of the issuer’s Milan inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Certain Munich U.S. government securities are backed by the full faith of the government. Obligations of U.S. government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. government. Portfolios New York that invest in such securities are not guaranteed and will fluctuate in value. Floating rate loans are not traded on an exchange and are subject to significant credit, valuation and liquidity risk.