Recently, we have seen a significant increase in demand for corporate bonds as investors look to secure relatively high income streams and a safe home for their capital. It can be challenging to look ahead, as we saw with the US Federal Reserve recently suggesting there may just be one interest rate reduction this year, against initial hopes of six at the start of the year. This perfectly reflects how important it is to be aware of factors that move corporate bond prices and how you can safeguard your capital.

 

Interest rate movements

 

As we have seen in recent months, there are two factors regarding interest rate movements and their impact on corporate bond prices. First, there is the assumption that interest rate movements are coming, which can see corporate bond prices move before the actual event. Then we have the actual interest rate movements, although as interest rate movements tend to be flagged to the market before the event, this can often be something of an anti-climax.

 

Credit ratings and default risk

 

Whether looking at investment grade, high yield or emerging market bonds, it's essential to be aware of the credit ratings for individual bonds and the potential default risk. It would be misleading to suggest that the markets "get it right" all of the time, but a substantial premium tends to indicate something is wrong or there is an enhanced risk of default. Unfortunately, some major credit rating agencies can be behind the times, as we saw with the demise of Lehman Bros and Silicon Valley Bank, both still holding relatively high credit ratings just before collapsing.

 

Global events and the economy

 

As we have seen with the Ukraine-Russia conflict, global events can significantly impact the worldwide economy. This, in turn, will impact the policies of central banks and governments, with a knock-on effect on corporate bond prices and general investment markets. However, there is an element of mystery about global and local economic trends because markets tend to look six months forward.

 

So, if, for example, the US economy was expected to recover from a recession within the next six months, it is not inconceivable that corporate bond prices would take this into account. Therefore, the recessionary experiences of individuals and companies could appear detached from corporate bond prices at the time.

 

Underlying company performance

 

While there is a disconnection between corporate bonds and equities, there is still a strong connection with company performance and, in particular, the strength of the balance sheet. In the world of corporate bonds, cash flow is king and reflects the ease with which a company is able to cover financing costs. At this point, it's important to appreciate that many companies will have multiple corporate bond issuances and significant ongoing finance costs.

 

Yield to Worst (YTW)

 

One factor often overlooked is the Yield to Worst (YTW), which reflects the lowest possible yield from a bond operating within the provisions of the initial contract - without defaulting. Many bonds have conditions that could trigger an early redemption before the original maturity date. Corporate bond research houses will have all of this information to hand, which is why they tend to offer significant value to investors. Automatically assuming your bond will go full term can be dangerous.

 

Summary

 

A number of factors dictate the direction of the wider corporate bond market and individual corporate bond prices. As interest in corporate bonds continues to rise, many investors are attracted by the yields and cash flow although it's important to be aware of the finer details. As with any investment, it's very dangerous to assume, and you could pay the price.

 

 

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