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Investment Risk Guide - Part 2: Corporate Credit

 

The first thing you notice when you look at all the ways in which to lend money to corporations, is the sheer number of the individual securities you can buy. There are more than 30,000 companies that are actively issuing bonds, and because they do it every so often, there are consequently many hundreds of thousands of individual bonds with varying maturities one can choose from. By some distance, the corporate bond markets are the most fragmented of all asset classes. It’s akin to going to an ice cream shop and being given the choice of many thousands of flavours, but from there you also have to decide which texture the mix of cream, milk and sugar would have to be.

 

So how does one lend money to a corporation? The first thing one has to understand, is that unlike government bonds where most things are fairly congruent and also safe (low risk, low return), with corporate bonds you really have to be very careful in case something goes wrong. Companies can’t print money or have central banks to bail them out, and they can fail to pay back their debt. The rating agencies (Moody’s or Standard & Poor) can help us with this assessment, as they quantify the ability of the company to meet their liabilities and monitor any changes in business conditions. The buyer must still beware though, as even the best analysts can get it wrong (see 2008) and the future is still random.

 

Then there are the private markets and unlike the bonds you can trade on public exchanges, these loans are made based upon individually negotiated contracts and they are made to term. In other words, if you enter into an agreement with XYZ corporation to lend them money for 2 years, you actually have to go without your cash until you get paid back the loan upon maturity. Needless to say, there are endless amounts of individual lending agreements that are done on a daily basis across thousands of companies all over the world, and as such there are also many different opportunities for providing credit to companies directly.

 

Finally, we have to decide for how long we are going to invest, in which countries, and what level of security we require in case something goes wrong. Generally speaking, the longer the loan, and the lower the quality of the borrower (in financial terms), the higher the interest we can receive. Some countries are riskier than others, which is again something that is directly reflected in the yield. For the most part, corporate bonds trade at a premium (higher yields) to local government bonds and there is a reason for that. When markets come under duress, government bonds increase in value, as that is what people buy in times of uncertainty. Whereas, corporate bonds will lose in value, as investors take risk off the table, which makes them very different kettles of fish indeed.

 

Please look out for our next post on Structured Credit in this six-part series, as we look into all the core risk categories.

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