Banking » Investing » Investing In Corporate Bonds – The Pros & Cons
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Investing In Corporate Bonds – The Pros & Cons

Companies turn to the corporate bond market to raise money essentially by borrowing them through their corporate bonds. But is it the right investment? In this article, we review the different benefits of corporate bonds for investors, which things you should be aware of and what are the main risks in this kind of investment:
Author: Baruch Mann (Silvermann)
Baruch Mann (Silvermann)

Writer, Contributor

Experience

Baruch Silvermann is a financial expert, experienced analyst, and founder of The Smart Investor.  Silvermann has contributed to Yahoo Finance and cited as an authoritative source in financial outlets like Forbes, Business Insider, CNBC Select, CNET, Bankrate, Fox Business, The Street, and more.
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Author: Baruch Mann (Silvermann)
Baruch Mann (Silvermann)

Writer, Contributor

Experience

Baruch Silvermann is a financial expert, experienced analyst, and founder of The Smart Investor.  Silvermann has contributed to Yahoo Finance and cited as an authoritative source in financial outlets like Forbes, Business Insider, CNBC Select, CNET, Bankrate, Fox Business, The Street, and more.
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Table Of Content

While comparing the composition of corporate bond ownership in the United States, non-US investors lead by 27% and 28%, respectively, according to the FED data

 

What Exactly are Corporate Bonds?

You may have heard many investors, brokers, bankers, and professionals liberally mentioning this term on many occasions but have no idea what they really are about. Corporate bonds are yet another instrument that corporations use to generate much-needed cash for their needs.

Normally, a company that wants to expand its operations or maybe infuse capital into a new venture would need a substantial amount of money.  And often, they would not want to touch what they have in reserve or what they have set aside for the current year’s overhead.

This is where the corporate bonds come into the picture.  Companies turn to the corporate bond market to raise money essentially by borrowing them through their corporate bonds. First, the company makes some projections and decides how much they would like to borrow.  Next, they would issue a bond offering equivalent to that amount.

Is it right time to invest in corporate bond fund?

Key Takeaways

  • A corporate bond represents debt security, issued by a company to raise funds. Those types of bonds are typically issued in the blocks of $1,000.
  • One of the key advantages of investing in corporate bonds is the fact that they usually pay a higher interest rate than compared to government bonds. This can be especially attractive for income-orientated investors.
  • Another major advantage of investing in corporate bonds is the possibility of choice. There are corporate bonds that offer fixed interest rates, while some other bonds are linked to the consumer price index, federal funds rate, or some other indicator.
  • One of the downsides of investing in corporate bonds is the fact that they are usually considered riskier than US government bonds. The fact of the matter is that in the case of company insolvency, investors might lose some or all of their investments.

How do Corporate Bonds Work?

The bond instrument is technically a loan instrument between the company (that issued the loan) and the investor (who bought the bond).  In it, they spell out the terms of the bond where there is an obligation by the issuer to repay the principal (borrowed amount) by the maturity date plus any interests in between.  Get it?

The maturity date may be a year or less (short-term), or two to ten years (intermediate-term) and most are from ten to 30 years or even longer (long-term).  You may hear the term ‘notes’ also used interchangeably for the bonds but professionally, they denote bonds that will mature in less than 10 years.

Bonds come with a face value (also known as par value) which represents the amount that the issuer will repay at maturity.  Corporate issuers usually issue bonds in blocks of $1,000 face values – which means that the investor should expect to receive $1,000 on the bond’s maturity date. 

There are also baby bonds, or those that have a face value of $500. Let me explain though that even if the face value stands at $1,000, that usually is NOT what you will pay for it in the bond market.

Corporate Bond – Example

Let’s say you purchase a bond with a 6% coupon rate or simply, a 6% bond from XYZ Corporation.  Like any common corporate bond, it carries a face value of $1,000.  Quite plainly, it means you stand to receive $60 as interest every year (or $1,000 x 0.06).

Many corporations find it better to pay in six-month installments which means, (for this example) you will receive $30 in January and $30 in June.  You can find this schedule in the prospectus, the indenture agreement and the bond certificate. 

How Does Inflation Affect Corporate Bonds?

With inflation rates rising to their highest level in recent years, and the Federal Reserve set to raise interest rates to pull the plug on rising consumer prices, this may be the best time to invest in corporate bonds. The economy has rebounded strongly from the pandemic. Corporations are in a much better financial position than they were before the pandemic. Some such as banks have instituted share buybacks.

Also, the recent earnings reports being released that companies are doing well, with most struggling to keep up with demand. In such a scenario, buying corporate bonds may be a very good investment strategy. The yields from the bonds can be used to offset the effect of inflation and provide a source of steady cash flow to investors.

Corporate Bonds Advantages

Investing in corporate bonds give you some distinct advantages such as:

The good news to an investor is:  you have a wider choice of where to invest your money when it comes to corporate bonds.

  There are so many types in the market that you’re bound to find one or two that really fit your requirements.  You can take your pick from short-term bonds that will mature in five years or less or from medium-term bonds with five to 12 years maturity.

If you’re the type who of investor who does not want to keep checking your portfolio all the time, there are long-term bonds that take more than 12 years to mature.

Aside from the differing maturities, investors can also pick their preferred coupon structures among many choices.  There are bonds that have a zero-coupon rate and by their name, they do not make any regular interest payments.

The government or its agencies and companies mainly issue these bonds but investors make a profit because they can buy them at a discount to their par value.

  • Zero or Fixed Rate

There are bonds with a fixed coupon rate and these pay a constant interest payment until their maturity date.  Investors can find bonds that pay on an annual or semi-annual basis as they prefer.

  • Floating Coupon Rates

Issuers set the interest rates for bonds with floating coupon rates by benchmarking them against acceptable indices such as the Consumer Price Index (CPI) or the London Interbank Offered Rate (LIBOR).  Of course, they would normally add a certain number of basis points (bps) to the benchmark to arrive at the final rate.  As the name implies, the interest payments will change correspondingly with the movements of the benchmark.

  • Step Coupon Rate

Another type of coupon structure is the step coupon rate where the interest payments escalate at predetermined times. This means that the investors will not receive the same amount but an increasing amount at each interest payment date. Majority of these securities carry a call provision which guarantees that the investor will receive the initial interest rate up to the stated call date.

When the bond reaches the call date, the issuer has the option to either call (or pay) the bond or increase the interest rate.

You’re dead right to say that corporate bonds are riskier compared to government bonds, municipal bonds or other types of bonds.  But you know that in the world of investment, the riskier instruments often provide a bigger chance for a higher return.  It’s the same thing with corporate bonds.

Here’s the kicker:  if your bond is from a reputable company, even if the interest rates fall, you can sell the bond in the secondary market and might still realize a decent profit and get cash.

On top of this, you can take your pick based on the different levels of credit risk among different corporate bonds.  Well, technically, this credit risk is attributable not to the bond per se, but to the company that issued it.  So, you can select what bond you want from the highly creditworthy to the high yielding ones (experts call them “junk”).

When you get lower-quality bonds, you actually introduce greater diversification benefits into your portfolio.  This is because the more credit risk there are in a bond, the less it performs – unlike high-quality sovereign bonds like US Treasuries, UK Gilts or German Bunds.

One thing good about corporate bonds is that there is a high amount of certainty about the interest payments you will get at the appointed time.  When you take out a loan to purchase something, you will have to regularly pay interest for the loan at certain intervals.  This is how the coupon payment structure works – with the parties reversed.

Some companies even give dividend payments and other benefits at their discretion, of course.  What it means for you is that you’ll have more certainty about getting a return for your investment.

If you check the secondary market, you will find that many investors and brokers are actively trading corporate bonds.  Because of this, investors can have access to their bond’s principal even before their maturity dates.  Like other instruments in the market, some bonds can move quicker and you may find that it is more difficult to dispose of bonds that do not trade as often.

Also, because you will be dealing with other investors, you may receive higher or lower than the price you originally paid for your bond.  It is a good practice to check the bond’s total issuance and trading history before purchasing it to ensure that it can provide liquidity should you need it.

Corporate Bonds Disadvantages

Investing in bonds can also have the following disadvantages:

The fact of the matter is, corporate bonds generally get lower credit ratings and of course, higher credit risk vis-a-vis U.S.  government bonds. The corporate bonds only carry the guarantee of the companies that issue them.  And it all boils down to the credit quality of the issuing company but it runs the whole spectrum:  some issuers have a AAA rating but there are also those with a C or lower.

When you buy corporate bonds through brokerage firms, you must take it upon yourself to monitor the risk of such bonds.  Your brokers or financial advisors will not and can not do this for you.

However, if you invest in managed portfolios, that is a little better because the asset management firms hire credit experts to monitor each and every security that they own.  Another good way to be able to access corporate bonds is by investing in mutual funds.

Normally, a mutual fund will own many hundreds of positions such that they spread out the default risk among them.

Some corporate bonds can become difficult to sell or exchange without drastically reducing their prices.  Investors who want to sell these securities are well aware that different variables could affect their transactions.  These include the interest rates, the bond’s credit rating and the size of their position.

Chances are that you may not even be able to find interested buyers for your corporate bond on the secondary market.  If you happen to be an investor who is in dire need of cash at the moment, this could be a very stressful situation.

There is an interesting inverse correlation between the bond prices and interest rates. When interest rates fall, the price of bonds in the marketplace generally goes the other way.  And conversely, when the interest rates go up, the prices of bonds normally go down.

Here's the explanation:  when interest rates are going down, many investors will try to capture or lock in the highest rates for as long as they possibly can.  The technique is to buy every available bond that pay a higher interest rate than the current market rate.  This will cause the demand to rise which causes an increase in the bond price.

Reversing the situation, if the current interest rates are going up, investors would naturally dispose the bonds that pay the lower interest rates.  This sudden selling would flood the market with bonds, causing the bond prices to go down.

 

Should You Invest in Corporate Bonds?

If you are planning to invest your money in corporate bonds, use this checklist to help you decide if that will be a good move for you.

  • When is the bond’s maturity date?
  • How many years are the bond’s terms?
  • Would you receive interest at a fixed or floating rate?
  • In case it is a floating-rate bond, do you have a clear understanding on how to compute for the interest?
  • Does the company that issued the bond have the financial capability to pay your interest and return your principal at maturity?
  • Do you understand that there’s a real risk that you may lose money if your sell your bonds on the market?
  • Are the bonds classified as secured or unsecured?
  • Where are you, in terms of payment priority, if the issuing company cannot repay its debts?
  • Can the issuer of the bond buy them back from you before the maturity date?

The Smart Investor content is intended to be used and must be used for informational purposes only. We are not an investment advisor and you should NOT rely on this information to make investment decisions .

How to Choose Corporate Bonds For Your Portfolio?

When choosing corporate bonds for your portfolio, one of the first things to consider is the rating of the bind. Rating agencies usually rate binds according to their level of risk default. Letter grades range from AAA or Aaa to BBB or Baa are considered investment grade. These bonds are considered safer aa they are less likely to default on coupon payment. Another factor to consider is interest payments.

Corporate bonds usually have high yields, but you would want to get the best value of your money by going for one with a higher yield. You should also look at maturity date as this would determine when you can get your capital back.

FAQs

High-yield bonds (also referred to as “junk” bond)  are essentially a corporate bond, but one that is issued by a company with poor financial health. High-yield bonds are more likely to default, and as such, pay a higher yield than investment-gradeor government

bonds to compensate investors for their risk.

While issuers of corporate bonds tends to be companies that are financially sound, issuers of high-yield debt tend to be start-up companies or capital-intensive firms with high debt ratios. In some casehigh-yield bonds are issued by fallen angels that lost their good credit ratings. Of all bond categories, investing in high yield binds carries the most risk. For example, in 2008, high-yield bonds as an asset class lost 26.17% of their value in just one year.

Municipal bonds are debt securities issued by states, cities, counties and other governmental entities to fund day-to-day obligations and to finance capital projects such as building schools, highways or sewer systems. On the other hand, bonds are those which are issued by private corporations. Municipal bonds have a lower interest rate to corporate binds because they carry a lower risk of default because they have the backing of the local government. 

Also, yields on a municipal bond is usually exempt from federal taxes, but there may be state or local taxes depending on your state. Some states give tax exemption to individuals that purchase bonds issued by their states or localities.  On the contrary, yields on corporate bonds are taxed.

There are two key ways that a corporate bond investor might profit from his or her investment. The first option is to keep the bonds until they reach maturity and earn interest payments. Coupons (interest on bonds) is paid every 6 months. The interests can be reinvested and compounded to increase profit. The second strategy to profit from bonds is by selling them at a profit in the secondary market.

For example, if you purchase $100,000 worth of bonds at face value and  then sell them for $110,000 when their current market value increases, you have gained $11,000, 

 

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Picture of Baruch Mann (Silvermann)

Baruch Mann (Silvermann)

Baruch Silvermann is a financial expert, experienced analyst, and founder of The Smart Investor.  Silvermann has contributed to Yahoo Finance and cited as an authoritative source in financial outlets like Forbes, Business Insider, CNBC Select, CNET, Bankrate, Fox Business, The Street, and more.
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