Investing in corporate bonds?

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1 Investing in corporate bonds? This independent guide fro the Australian Securities and Investents Coission (ASIC) can help you look past the return and assess the risks of corporate bonds.

2 If you re thinking about investing in corporate bonds Contents Read this guide together with the prospectus for the corporate bonds. The return offered is not the only way to assess this investent: ake sure you understand the risks. The inforation in this guide is general in nature. To work out a detailed strategy that eets your individual needs, consider seeking professional advice fro a licensed financial adviser. Your investent checklist 4 Use this investent checklist to ake sure you understand how corporate bonds work and whether they eet your investent needs. Know what the investent is 6 What is a corporate bond? Do your own research 12 Always read the prospectus and research the copany issuing the corporate bonds if you re thinking of investing. Reeber Anything you put your oney into should eet your goals and suit you. No one can guarantee the perforance of any investent. You ay lose soe or all of your oney if soething goes wrong. Bond basics: Things you need to know before investing 14 Understand the key features of corporate bonds and assess the risks of this investent. Tips for reading a prospectus 36 Unpack the jargon in prospectuses for corporate bonds. Visit ASIC s website for consuers and investors at for ore independent inforation fro ASIC about what to watch out for when investing.

3 Yes No Do you know when the bonds ature (the aturity date)? If no, see page 16 Your investent checklist Do you know the length of the bonds ter in years? If no, see page 16 Do you know if interest is paid at a fixed rate or floating rate? If no, see page 18 If they are floating rate bonds, do you understand how the interest rate is calculated? If no, see page 18 This checklist can help you decide whether corporate bonds are the right investent for you. Do you know how often you will be paid interest? If no, see page 20 Make sure you can answer the following questions before you invest your oney in corporate bonds. If you can t answer these questions, read the relevant sections of this guide. Do you know if the copany has the financial capacity to pay you interest and return your principal at aturity? Do you understand that you ay lose oney if you sell your bonds in the arket? If no, see page 22 If no, see page 26 Do you know if the bonds are secured or unsecured? If no, see page 28 Do you understand where you would stand in relation to other creditors if the copany issuing the bonds couldn t pay its debts? If no, see page 28 Do you know if the copany issuing the bonds can buy the back before the aturity date? If no, see page 32 Do you understand the risks of investing in corporate bonds? If no, see page

4 Know what the investent is What is a corporate bond? A corporate bond is one way for a copany to raise oney fro investors to finance its business activities. In return for your oney, the copany issuing the bonds (the issuer) proises to: pay you interest pay back the oney you ve invested (your principal) on a certain date. By investing in corporate bonds, you are lending your oney to a copany, with all the risks that this involves. For exaple, you ay not get your oney back if the copany issuing the bonds goes out of business. How is a corporate bond different to a debenture? A debenture is a type of corporate bond. To be called a debenture, a corporate bond ust be secured against property. Corporate bonds generally ay or ay not be secured against property. How are corporate bonds different to governent bonds, ter deposits or shares? Corporate bonds are copletely different to governent bonds, ter deposits or shares: A corporate bond is not the sae as a governent bond, which is a low-risk investent. A corporate bond is not the sae as a ter deposit, which is currently guaranteed by the Australian Governent s deposit insurance schee (for balances up to $1 illion). A corporate bond is not the sae as a share. If you buy a copany s shares, you have an ownership interest in the copany. If you buy corporate bonds, you are lending oney to the copany issuing the bonds. As a bond holder, you are considered a creditor. For a full coparison of corporate bonds with these other products, see Table 1 on pages 8 9. A debenture is also always a fixed rate investent, while corporate bonds ay be fixed interest or floating rate investents. This eans that the interest rate on the oney you lend is either set in advance (fixed) or linked to a variable interest rate (floating). Regardless of the type of interest rate, it s iportant to reeber that with corporate bonds (as with debentures), interest payents on your oney and the return of your principal are not certain. 6 7

5 Table 1: Soe advantages and disadvantages of corporate bonds copared to other investents Product Advantages Disadvantages Product Advantages Disadvantages Corporate bonds Ter deposits Regular interest payents Fixed-ter investent (unless you decide to sell your bonds on secondary arket, see page 11) Soe security (your bonds generally rank higher than shares if the copany can t pay all its debts) Governent guaranteed for balances up to $1 illion If the copany becoes insolvent (that is, it can t pay its debts), you ay not get interest payents and/or your capital back Risk that no one will want to buy your bonds on the secondary arket if you do not want to hold the to the aturity date Debt security ranking ay be low Lower interest rates Bank charges and fees Governent bonds Shares Regular interest payents Fixed-ter investent Governent guaranteed repayent of debt Low-risk investent Dividend payents Ownership interest in the copany Easily traded on secondary arket Lower interest rates Hard to access for retail investors You rank lower than other investors such as holders of corporate bonds Dividends subject to copany perforance Easy access to your oney 8 9

6 Why invest in corporate bonds? With corporate bonds, you norally get a regular incoe and a higher interest rate than ay be available on a ter deposit or other cash-based product. However, corporate bonds are not generally designed to give you capital growth (that is, the bonds you buy are unlikely to increase in value during the tie you have the investent). Can you lose oney by investing in corporate bonds? Soe investors believe that corporate bonds have little or no risk. But, like any investent, corporate bonds can be risky. The ain risk is that the copany issuing the bonds ight go out of business. This could ean you lose soe or all of your oney because the copany can t afford to pay all of the oney owed to its creditors, including you (this is known as credit risk). Corporate bonds are also subject to other investent risks like interest rate risk, liquidity risk and prepayent risk, see pages The prospectus for the bonds should tell you about these and any other risks. Corporate bonds are generally less risky than shares. How can you buy corporate bonds? There are two ain ways to buy corporate bonds: through a public offer (the priary arket) or through a securities exchange (the secondary arket). Priary arket (public offer) Most retail investors buy corporate bonds through a public offer. A copany that akes a public offer will issue a prospectus and investors apply directly to buy bonds. Many investors find out about these offers through newspaper advertiseents. The prospectus for an offer of corporate bonds generally specifies a iniu investent parcel (or bundle of bonds). People who invest in corporate bonds when they are first issued pay the face value of the bond (usually $100 each). If you buy corporate bonds through a prospectus, it is very iportant to read the docuent thoroughly (see Tips for reading a prospectus on pages 36 39). Secondary arket (securities exchange) You can buy (and sell) soe corporate bonds on the Australian Securities Exchange (ASX), just like you would for shares, after they have already been issued in the priary arket. If you buy bonds on the ASX, you will pay the arket price, which ay be higher or lower than the face value of the bond. You will also pay transaction fees (for exaple, coission or brokerage fees) to your broker

7 Do your own research Regardless of how you buy corporate bonds, it s iportant to understand the features and risks of the product before you invest. A good place to start if you re buying bonds when they are first issued is the prospectus. If you re buying the on the secondary arket (see page 11), the prospectus ay be out-of-date so the best place to get current inforation is the issuing copany s website or the ASX. Why is the prospectus iportant? The prospectus tells you how the investent works. It should tell you everything you need to know about the copany issuing the bonds, what it will do with your oney, and the ters of the investent. What inforation is available through the copany s website or the ASX? Many copanies put inforation on the bonds they have issued on their website. The inforation is typically found under the investor centre tab. Listed copanies ust also give inforation on their bonds to the ASX as part of their disclosure obligations. You can find this inforation on the ASX s website at under the copany nae. Soe investors find prospectuses hard to read and understand. It is very iportant that you carefully read the sections of the prospectus that: explain the key features and risks of the investent give you inforation about certain indicators that can help you assess the risks tell you about the tiing of interest payents and conditions around the. You should find this inforation in the first few pages of the prospectus. A prospectus ust be lodged with ASIC before it can be used to raise oney fro investors. However, this does not ean that ASIC has checked or endorsed the investent in any way

8 Bond basics: Things you need to know before investing To help you understand what you read in the prospectus, we ve put together a quick suary of the key product features and risks of corporate bonds. Even though this section is called bond basics, soe of the concepts are fairly coplex. The ters and conditions of corporate bonds vary widely and they can be structured in any different ways. That s why it s especially iportant for you to understand what you re putting your oney into before you go ahead. For ore tips on reading a prospectus and what the jargon really eans, see pages Maturity date and ter Does the ter of the corporate bonds suit your financial needs? 2. Interest rates Will you be paid interest at a fixed rate or a floating rate? 3. Interest payents Will the frequency of interest payents eet your incoe needs? 4. Financial capacity Does the copany have the financial capacity to pay you interest and return your principal at aturity? 5. Market value How will changes in the arket value of the corporate bonds affect you? 6. Security and ranking Will you be able to get your oney back if the copany can t pay its debts? 7. Early redeption Can the issuer buy the corporate bonds back early (and how uch interest ight you lose if they do)? 8. Investent risks Have you thought about the risks of this investent and are you cofortable with the?

9 1. Maturity date and ter The aturity date is the date on which your investent ends (atures). On this date, the issuer ust buy back (or redee) all of the corporate bonds issued to you. You can expect to get back the face value of the bonds plus any interest that has accrued since the last tie interest was paid to you. The aturity date is usually stated at the front of the prospectus as part of a suary schedule of the ters and conditions of the bonds being offered. For exaple, for an investent that has a lifespan of five years, under the heading Maturity, the prospectus ight say: The issue atures on the fifth anniversary of the issue date. Another way to describe a corporate bond with a lifespan of five years is to say that it has a five-year ter. Generally, in the Australian arket, corporate bonds are either: short-ter (aturity dates of up to one year) ediu-ter (aturity dates of one to three years) long-ter (aturity dates of ore than three years). The issuer ay be able to buy back the corporate bonds before the aturity date. This is called early redeption: see page 32. What s at stake for you? Check the ter of the corporate bonds and ake sure it suits your financial needs (for exaple, do you want to invest in an interest-paying investent over a three-year ter?) Unless you plan to trade listed corporate bonds on the secondary arket and can find a buyer for the, you will need to wait for your bonds to ature before you get your oney back. In the case of short-ter bonds, your oney will be tied up for one year. For ediu-ter and long-ter bonds, it will be even longer. If the issuer can buy back their bonds before the aturity date, this will affect any interest payents that you expect to get over the life of the bond. What would this ean for your incoe? 16 17

10 2. Interest rates Corporate bonds can pay interest at a fixed rate or a floating rate. Fixed rate The interest rate on fixed rate bonds is set when the bonds are issued and is shown as a percentage of the face value (usually $100) of the bond. The interest rate stays the sae for the life of each bond. For exaple, a $100 bond with an 8% interest rate will pay investors $8 a year in instalents of $4 every six onths or $2 every three onths (quarter). These instalents are called coupon payents. Floating rate The interest rate for floating rate bonds, as the nae suggests, varies or floats, in line with oveents in a benchark interest rate. The benchark rate is usually the variable interest rate for a bank bill for a three or six-onth ter. (Bank bills are short-ter investents between banks.) A fixed argin is generally added to the benchark interest rate to get the floating rate. For exaple, if the interest rate for a three-onth bank bill is 3.5% and the fixed argin is 4%, the floating rate will be 7.5%. What s at stake for you? If you invest in fixed interest rate bonds, you ll get the sae coupon payent every quarter or six onths for the life of the bond. This is iportant if you re depending on the interest payent for incoe. If you invest in floating rate bonds, the coupon payent will vary each tie, soeties quite substantially. You could get higher returns if the benchark interest rate goes up, but you also risk getting lower returns if the benchark interest rate goes down. The prospectus should tell you exactly how and when the floating rate will be calculated for coupon payents (this is often at the back of the prospectus under the ters and conditions)

11 3. Interest payents One of the ain benefits of corporate bonds is that, up to the aturity date, you will norally get a regular incoe fro interest payents on the oney you have invested. How often you can expect to be paid interest is called the payent frequency. Norally, interest on corporate bonds is paid every three onths (quarterly). Specific dates for the payents are shown in a suary schedule at the front of the prospectus, with ore detail at the back under the ters and conditions. Soe issuers include an option allowing the to adjust the payent frequency on a cuulative basis. This eans that, if the issuer can t pay your interest payent on the scheduled date, they will pay you an accuulated aount including interest on the next scheduled payent date. What s at stake for you? Check the prospectus for the schedule of interest payents. Does the payent frequency suit your needs? If the issuer can adjust the payent frequency on a cuulative basis, how will this affect your incoe and cash flow requireents? Issuers ay include this option to give theselves ore flexibility with their cash flow. Even though you will still get the oney you are owed, it will be worth less to you because inflation will have eaten away soe of the payent s real value due to the delay

12 4. Financial capacity When you buy corporate bonds, you are lending oney to a copany. You need to be sure that the copany can pay you interest each quarter and repay your principal at aturity. One way to assess whether the copany can eet its financial obligations is to review the pro fora financial inforation in the prospectus. While this ay see daunting given the volue and coplexity of this inforation, you can get soe idea by focusing on iportant financial etrics. What you need to know is whether you re dealing with a healthy copany with low levels of debt and plenty of cash to service it, or a troubled copany that is heavily in debt (leveraged) and cash-poor. Table 2 on page 24, highlights the key pieces of financial inforation that should help you work this out. What s at stake for you? A copany is less likely to be able to ake interest payents to you and repay your principal if: its financial perforance over tie has been lacklustre it has a low interest coverage ratio, or a high debt to equity ratio. Think about whether you are willing to risk your oney with such a copany

13 Table 2: Key indicators of a copany s financial capacity The copany s financial perforance over tie Copanies with a solid financial perforance history strong earnings, profitability and cash flow are uch better placed to eet their financial obligations. The copany s ability to pay interest on its debts (interest coverage ratio) A copany s earnings should be greater than its interest expenses that is, the copany should earn enough fro its business operations to cover interest payents on oney it borrows. Two coon interest coverage ratios are: earnings before interest, tax, depreciation and aortisation (EBITDA) divided by net interest expenses earnings before interest and tax (EBIT) divided by net interest expenses. Regardless of which ratio is used, ake sure that the copany s earnings are cofortably larger than net interest expenses. For exaple, if EBIT was $500,000 and net interest expenses were $100,000, the interest coverage ratio would be 5, which eans that earnings are five ties larger than interest expenses. The copany s level of debt or leverage (gearing ratio) A good indicator of a copany s level of debt is a ratio that easures total liabilities divided by shareholder equity (gearing ratio). The higher this ratio, the ore highly leveraged the copany. As with any ratio, what is appropriate can depend on the copany s business. Although the two ratios above are iportant, you should also take into account other credit indicators such as: whether the copany has defaulted on any current or previous debt obligations, or has breached any conditions on its loans (loan covenants), and whether the copany has a significant aount of debt that will be aturing soon, and which ay need to be rolled over (its debt aturity profile)

14 5. Market value Corporate bonds usually have a face value of $100 each, which is what you would pay if you bought a bond through a prospectus when it was first issued. If you buy or sell corporate bonds on the secondary arket, like shares, their price can vary fro day to day. There ay be several reasons for the difference between the arket price and the face value of particular bonds: see Table 3. Table 3: Influences on arket value Interest rates have changed When interest rates rise, new bonds ay be issued into the arket with higher returns than older bonds. This eans that the older bonds are worth less and their arket price falls. When interest rates drop, new bonds ay be issued into the arket with lower returns than older bonds. This eans that the older bonds are worth ore and their arket price goes up. The copany s credit rating has changed What s at stake for you? A rise or fall in the arket price of a corporate bond won t affect how uch oney you ll get back if you hold onto the bonds until the aturity date. In this case, you should be paid the face value of the bonds (that is, what you paid for the when they were first issued) plus any interest due to you since the last interest payent. If you re buying or selling corporate bonds in the secondary arket, though, the arket price will affect you. What you pay to buy the bonds or get for selling the ay be lower or higher than the face value, depending on the arket price at the tie you buy or sell. A credit rating agency ay decide to lower the credit rating for a copany s bonds (for exaple, if the copany isn t doing as well as it was when the bond was issued). Details of any significant changes should be announced to the ASX. If this happens, the arket price of the bond ight fall. On the other hand, the credit rating ight increase, leading to a higher arket price. There are fewer potential buyers If there are fewer potential buyers for corporate bonds, it ay take longer to sell your bonds at the price you want. This can be a proble if you need to get your oney back quickly

15 6. Security and ranking If you re thinking of investing your oney in corporate bonds, it s iportant to be aware of how likely you are to get your oney back if the copany that issued the bonds becoes insolvent (that is, if it can t pay its debts). When a copany becoes insolvent, its assets ay have to be liquidated, with the proceeds being distributed to everyone who has a stake in the copany. This eans all the creditors (including bond holders) and shareholders. There are two factors that deterine how likely you are to get your oney back: whether the corporate bonds are secured or unsecured and your ranking in the list of creditors. These things should be clearly described in the prospectus. Figure 1 on page 30 explains the security and rankings that usually apply to corporate bonds. We have included ter deposits and shares for a coparison. What s at stake for you? Check what the bonds are secured against and what your ranking is if the issuing copany becoes insolvent. Think about whether you can afford to lose soe or all of your oney if things go wrong. As a rule of thub, the holder of an unsecured and subordinated corporate bond is ranked higher than the holder of shares in a copany, but lower than a secured creditor (for exaple, the issuer s bank). This eans that, generally, if the issuing copany becoes insolvent and its assets are liquidated, you ay only get back your oney after all the secured creditors have been paid. Even then, you ay only get back part of your oney, depending on what is left over

16 Figure 1: Security and ranking for corporate bonds copared to other investents Ter deposits Security/ranking: Your deposit is secured against the current governent guarantee (for aounts up to $1 illion). What it eans: You will get all your oney back if the bank or other institution becoes insolvent, regardless of other debts it has. Corporate bonds Senior secured Security/ranking: The corporate bond is secured against copany property and you are ranked ahead of other secured creditors. What it eans: You ay get soe of your oney back before other secured creditors are paid. Corporate bonds Senior unsecured Security/ranking: The corporate bond is not secured against copany property but you are ranked ahead of other unsecured creditors. What it eans: You ay get soe of your oney back after secured creditors are paid, but before other unsecured creditors are paid. Corporate bonds Subordinated Security/ranking: The corporate bond is not secured against copany property and you are not ranked ahead of other unsecured creditors. What it eans: You ay get soe of your oney back after secured and senior unsecured creditors are paid, but before other copany debts are paid. Shares Security/ranking: You are ranked below all other creditors. What it eans: You ay get soe of your oney back after all the copany s creditors have been paid

17 7. Early redeption Early redeption eans that the issuer can buy back the corporate bonds before the aturity date. If the issuer redees the bonds early, they will usually pay you the face value of the bond with any accrued interest to date since your last interest payent. Although it s less coon, you ay also be allowed to ask the issuer to redee your bonds before the aturity date. The prospectus should tell you the circustances under which early redeption is possible. This will be either unliited redeption or specified redeption. Specified redeption This eans that the issuer can only redee the bonds before the aturity date if certain events occur as specified in the prospectus. An exaple of a specified event ight be if the project the bond was issued to raise oney for is a joint venture and a key partner pulls out. Unliited redeption This eans that the issuer can redee the bonds at any tie. What s at stake for you? If the issuer redees the bonds early, you will iss out on any potential interest you would have earned. You ay also end up paying extra costs if you decide to re-invest your oney in soething else. If you bought the corporate bonds on the secondary arket, you could also lose oney if the issuer redees the bonds early. This is because you will probably be paid the face value of the bonds, which ay be lower than the arket price you paid for the

18 8. Investent risks Soe investors think that corporate bonds are about as risky as governent bonds. This is not the case. They are ore risky than governent bonds. The prospectus should tell you about the risks that apply to corporate bonds generally (see Table 4) and any other risks that ay apply to the particular bonds. What s at stake for you? Although corporate bonds are less risky than shares, you could still lose soe or all of the oney you ve invested. Make sure you understand what the risks are and whether you can afford to take the with your oney. Table 4: Types of risk and what they ean Credit risk This is the risk that the issuer ay not be able to pay back the oney they owe on the bonds they have issued (that is, they ay default on interest payents to you, or not be able to pay back the oney you originally invested). Interest rate risk This is the risk that the arket value of the bonds will go up and down as interest rates go up and down. For exaple, if interest rates go up, the arket value of corporate bonds will generally go down (this eans you ay get less oney for your bonds if you re planning to sell the on the secondary arket than what you initially paid for the). Liquidity risk This is the risk that you won t be able to sell your bonds when you want to at the price you want to because there aren t any buyers for the bonds. Prepayent (or early redeption) risk This is the risk that the issuer will redee the bonds early if interest rates fall and the arket price goes up. If this happens, you will be paid the face value of the bonds (you ay have paid ore for the or they ay be worth ore on the secondary arket)

19 Tips for reading a prospectus Figure 2: Key features of the corporate bonds (presented in a prospectus) What inforation will you usually see in a prospectus? Figure 2 highlights the ost iportant issues and risks for you to check in a prospectus. To find out what the jargon really eans, see the explanations below. Prospectuses for corporate bonds vary depending on the copany issuing the bonds. So this is only an indication of the inforation to look for. What does it ean? 1 This is the copany issuing the bonds Each bond costs $100. You ust buy at least 50 bonds. We want to borrow $200 illion but reserve the right to borrow ore or less. We will pay you $100 per bond plus accrued interest on 1 May The interest rate on these corporate bonds is a floating rate based on a arket-deterined rate (the variable rate for a three-onth bank bill) plus a fixed interest argin of 4.25%. This eans that your interest payents will vary. If you buy and hold 100 or ore bonds (up to a axiu of 500 bonds), the interest rate on your bonds will be 0.25% higher in the first year. You can expect your interest payents on these dates. (This is a saple only. The schedule of payents will vary depending on the issuer)

20 This is the period of tie during which interest will accrue on the oney you ve invested. If interest payents are ade every quarter, the interest period would be roughly three onths. You should be able to buy or sell these corporate bonds on the ASX. The corporate bonds are unsecured (that is, they are not secured against copany property). If you invest in these corporate bonds, your ranking will be Senior unsecured. If the issuer becoes insolvent (that is, can t pay its debts), you ay get soe of your oney back after secured creditors (like the issuer s bank) are paid but before other unsecured creditors are paid. A ranking of Subordinated is lower and is usually unsecured. The group of copanies that the issuer belongs to will guarantee the issuer s obligations including paying you interest and paying back the oney you invested (your principal) if and when necessary. The issuer can buy back these corporate bonds early (that is, before the aturity date) and ay do so if any of these events occurs. With ost corporate bonds, you will not have the sae right. Like any investent, corporate bonds can be risky (for exaple, the copany ay becoe insolvent or you ay not be able to sell your bonds in the secondary arket). Make sure you understand and carefully weigh up the risks set out in the prospectus before you invest your oney

21 Misleading advertising? Hard sell? Have you coe across an advertiseent for a financial product that you think is isleading? Or have you been pressured by a sales person to ake a decision when you didn t have enough inforation, or weren t sure that the product was right for you? Phone ASIC on to tell us about it. You can lodge a foral coplaint at See for soe strategies to help you resist pressure selling, so you don t end up investing in a financial product that doesn t suit your needs. For ore inforation on what to look out for in general investing, go to The Australian Securities and Investents Coission consuer website, FIDO, offers you financial tips and safety checks. For consuers and investors: or call ASIC s Infoline on ISBN Australian Securities and Investents Coission, Deceber 2009 This publication is printed on Sovereign Offset.

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