Bonds offer an alternative to the security conscious

If you're in the market for an investment with a touch of risk, then the corporate bond could be the ideal choice

So you've tried stocks and shares and decided for one reason or another that they're not for you - where do you go from here? There's always gold, or perhaps the precious stones market if you're feeling a bit flighty. Maybe you've always fancied the rough and tumble of the international art trade, but have never quite made it into the right circles.

If security of return and outlook are more your thing, however, then perhaps bonds present a more appealing possibility. If you're looking for a way to combine bonds with a touch of risk, then corporate bonds could be the investment option you've longed for.

Corporate bonds work much like their government counterparts, in that they provide a given body with a way of raising money by issuing a debt obligation. In simple terms, a corporate bond is the equivalent of an "IOU" that an individual might scribble on a scrap of paper in a poker game.

The difference is that they tend to be issued in denominations of thousands and are accompanied by an enforceable legal promise from the corporate group to return the money at a specified date in the future, at least three years out.

It all sounds like a good deal for the corporate issuer, but the attractions for the institution or individual buying the bond are, at first glance, a little less clear. While the corporate group goes off and splashes the cash on a new roof for its factory, what does the lender get out of the whole deal?

The first key benefit is one that is a characteristic of almost any regulated loan: interest payments. When the bond is issued, the corporate body will usually undertake to pay a standard rate of interest at fixed points throughout the life of the loan. These payments will generally come twice a year and will be higher than those offered by government bonds because of the raised risk inherent in bonds that are not guaranteed by the state.

The other, and potentially more lucrative, payback comes in the massive trade that corporate bonds attract around the world every year. The US-based Bond Market Association estimates that the US market sees trading volume of about €15 billion in an average day, with all the buyers and sellers banking on making a buck before their bond reaches "maturity", or redemption date. This means that the trade value of a bond can rise as well as fall, much like any other marketable investment.

The main driver behind these fluctuations is the interest-rate environment, and how it looks at a given time. The underlying premise is that rising interest rates will spawn falling values for corporate bonds, and vice versa.

This correlation is easily explained: a rise in interest rates will generally inspire a number of new corporate-bond issues that carry higher yields than their older equivalents. This will automatically cause the older corporate bonds to drop in value. As interest rates fall, the process happens in reverse.

In broad terms, there are three kinds of corporate bonds, with classification depending on the term of the loan. Short-term notes generally imply a maturity of five years or less, while medium-term notes tend to have a life of 10 years or so. Long-term bonds, meanwhile, will have a maturity of more than 10 years.

The extent of this trading will, in turn, affect the yield, or the return an investor can expect to make on their bond. Yields are a crucial part of life for any bond investor, and should be used as the basis on which any "buy" or "sell" decisions are made. Unfortunately, yields are not fixed, and will change to reflect a bond's price movements.

In simple terms, it works like this: investor A buys a corporate bond today at 4 per cent interest. Interest rates rise and, a year from now, investor A sells the bond at a lower price than was originally paid. Investor B buys the bond and, while they receive the rate of interest and the same monetary amount of return as Investor A did, they earn a higher yield because of the lower price they paid.

The Bond Market Association advises that most investors will be concerned with two types of yield: the current yield and the yield to maturity. The current yield reflects the annual return on the amount paid for the bond, regardless of maturity date, while the yield to maturity states the total return an investor would receive if they held the bond for its full term.

The association argues that the yield to maturity is the more informative of the two measures because it allows comparison between bonds with differing terms.

So far so good. We understand yields, interest rates and maturities. But of course the technicalities don't stop there. Any corporate-bond investor worth his salt must be in a position to understand every single provision of the indenture that sets out the terms of their investment.

One of the most tricky of these is the "call" clause, whereby an issuer retains the right to redeem their debt at a time before the agreed maturity date. Since this automatically implies a risk for the investor, bonds featuring a call will generally carry higher yields than a more straightforward issue.

Before getting lost in a sea of financial jargon however (see panel on credit ratings), corporate bonds should be placed in perspective, particularly in the Irish context. While the international corporate-bond market is highly liquid - frequent trades in large volumes - the Irish equivalent is a much quieter affair.

AIB chief bond economist, Mr Oliver Mangan, says the Irish corporate bond market can be accessed in the same way as the stock market, with most stockbroking houses offering trading facilities in domestic issues. The companies involved in this market tend to be the larger corporates, with AIB itself chief among the issuers. Mr Mangan says Irish corporate bonds will generally come with a health warning that reflects their highly illiquid nature. "A lot of them are difficult to sell," he says. "Institutions buy them at issue to keep them. The international ones are more liquid."

As far as yields are concerned, a 10-year Irish corporate bond will carry about 5.5 per cent, about 0.3 per cent above the EU benchmark rate for government bonds.

As Mr Mangan says, however, the chances of the German government definitely being around in 10 years' time may be somewhat higher.