Question

Describe the features of corporate bonds and explain how they differ from other types of bond such as the UK government bond. Explain why investors may find it necessary to include Government and/or Treasury bonds in their portfolios of corporate bonds investment. In what way does the portfolio theory support this kind of investment strategy?

Word count required: 300-350 words

Answer 1

Features of corporate bond:

1 Interest payments schedule and conditions:

These bonds contains predetermined information of coupon or interest rate. This is because yield is determined by face value and it's interest rate. Also payment schedule is also mentioned.

2 maturity date:

Date of maturity is specified in corporate bonds. Principal and interest payments are due on this date. Various maturity are available from short, intermediate to long. Less maturity usually means less volatility in price for corporate bond.

3 call provision:

Issuer of corporate bond offer bond with call provision which would help him pay face value earlier than maturity if desired. Such provision provide issuer an opportunity to get out of contract and prevent from paying high interest payments if interest rate rises.

4 call protection:

It ensures that payment would be made for certain duration before calling a bond.It would prevant the risk of early call from issuer of bond.

5 credit rating:

Interest rate paid by a corporate bond is influenced by it's credit rating. It's credit rating acts as indicator of quality of bond and whether it will default or not. Higher credit rating bonds pay low interest but are less likely to default, while low credit rating bonds pay high interest but are at high risk of default.

Other valuable features can be issuers's performance, liquidity of issue and weather or not it is an insured bond.

When compared between corporate bonds and other bonds like government bonds, government bonds usually don't pay coupon interest like corporate bonds do. Coupon paid by corporate bonds are fixed while government will pay set level of interest for a particular period and these interest rates keeps fluctuating overtime with market conditions. Interest rate paid by government bond is less as compared to interest paid by corporate bonds. On the other hand, corporate bonds are riskier than government bonds as corporate bonds contains interest rate risk, Market risk, credit risk.

Including government bonds in a portfolio of corporate bonds will be beneficial for diversification as it will lower the portfolio risk and ensure higher returns from corporate bonds.

Modern portfolio theory tells how risk averse investors can construct portfolios to optimize or maximise expected returns on given level of market risk, as it is possible to construct an efficient portfolio of optimal return by diversifying the portfolio and reducing variance and standard devation of returns in portfolio.