Why corporate bonds are so risky
- Marcel Shackleton
- Sep 22, 2024
- 3 min read
Updated: Sep 27, 2024
Corporate bonds, seen as alternative investments and exclusively marketed to high net worth individuals and sophisticated investors, seem to offer a very attractive alternative to the income vehicles like ISAs, FTSE shares, property or especially government bonds. The returns are seen as much higher, fixed, and usually have asset-backing securing the bond.
The risks cannot seem so apparent from an initial presentation, however there is a lot behind the scenes which investors are often not aware of.
The inherent risks in a corporate bond are evident from the actual structure of the bond itself.
A few years ago there was an explosion of mini-bonds that hit the City. These bonds typically offered 5-year terms, at 10% per annum income.
The problem is in the basic maths.
If a bond raises £5M, then they are liable for £500,000 in income payments each year. This cannot be paid out of the £5M raised or it becomes a Ponzi Scheme.
This means that for borrowing £5M, the bond is responsible for £7.5M in debt with large repayments due, almost immediately, and from fresh capital. This puts the bond under great pressure to generate large funds almost immediately and doesn't even factor in why the bond issuers needed the £5million in the first place. It is assumed that that capital was earmarked for a business venture. So there is no capital available at the very beginning for income repayments within a year, these fresh funds need to be generated immediately.
Some bond issuers offer quarterly payments or 6-monthly payments, These put the company under even more pressure to pay themselves, invest in their project, generate profits and pay bond income payments out of profits, after their costs have been deducted.
There are a large number of corporate bonds who default on this payment. There are an even larger amount of bonds that stretch the rules and pay that first income payment from the raised capital.
For bonds that struggle and collapse, there is always the comfort that the bond was "asset-backed". There have been problems with this too.
There are trustee companies who take on the responsibility of overseeing the asset-backing of these bonds, with it being claimed that the trustee has the authority of seizing the assets of the bond issuer to pay back bondholders if they default.
Problems here have materialised when the trustee's annual fees are not paid by the bond issuer, meaning that the trustee has no legal obligation to act on the behalf of the bondholders once its contract has expired.
The pressure to pay annual income is immense alomost immediately, and on maturity the bond issuer is liable for paying the whole £5M back to its investors at once.
There has to be a huge cash-generating business plan ready to launch immediately to afford the repayments and there has to be sufficient asset-backing and a sufficient trustee contract which is clear about their responsibility and about exactly which assets or properties underly the bond.
There are bond opportunities out there that are excellent, but they are incredibly rare. One bond that UK Investment Agency management was involved with recently built a renewable energy plant successfully and was ready to begin trading in time to generate the funds needed to honour the bond repayments, but hadn't factored in the government's 6-month waiting time to issue a license, so the bond directors had to explain to all bondholders why there was a 6-month delay in their bonds maturing.
There are a multitude of reasons a corporate bond can have difficulties or fail. The pressure of the enormous financial commitment made by the bond issuer is the main one. Having said that, if a company has the right business model and plan, they can be successful.
It all depends on the opportunity and company.
These opportunities are in stark contrast to the London Capital and Finance (LCF) debacle in the market a couple of years ago. They were offering a regulated ISA paying an impossible and illegal rate on people's normal ISAs and raised hundeds of millions. This was just a scam and they people responsible are being brought to justice.
Alternative investing means taking on normal, business risks. Fraud is a different case entirely and the two should not be confused. Alternative investing is legimate and important.
Having said that, corporate bonds are a way for business entrepreneurs to embark on a venture, have no vested interest and have no losses should the bond fail. All the high risk is assumed by the bond holders alone.
For these reasons, UKIA often overlooks corporate bond offers when they circulate.
The UK Investment Agency (UKIA)
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