Investors considering fixed-income investments might want to consider corporate bonds, which some have described as the last safe investment. Investment-quality corporate bonds can provide a steady income and allow the investor to avoid, or at least offset, the turmoil of the stock market.
But corporate bonds have their own unique advantages and disadvantages for investors to consider.
Key Takeaways
- Corporate bonds are debt securities that companies issue in order to raise capital.
- These bonds are often seen as the "yin" to stocks' "yang", and are a key component of a diversified portfolio.
- Corporate bonds are diverse and liquid and are less volatile than stocks, but they also provide generally lower returns over time.
Advantages of Corporate Bonds
Corporate bonds generally have better returns than government bonds.
Many individual investors, especially retirees, buy and hold bonds in order to obtain a steady income stream. They rarely or never sell the bonds, holding them until they mature and then rolling over the cash into newly-issued bonds.
Others trade bonds in the secondary bond market. This is where existing bond issues are bought and sold at a discount or a premium of their face value as the direction of new bond issues make them less or more valuable to investors.
Liquidity
Their liquidity is one advantage of corporate bonds. Active bond traders can benefit from selling bonds that have risen in price or buying bonds after they decline in price.
Some corporate bonds are thinly traded. That means there is relatively little demand for them, and trading them profitably can be difficult.
Investors considering selling corporate bonds should be aware that numerous variables can affect their transactions, including current interest rates, the credit rating of their bonds, and the size of their position.
Choice
Bond investors can buy short-term bonds with maturities of five years or less, medium-term bonds that mature in five to 12 years, or long-term bonds that mature in more than 12 years.
Beyond these considerations, corporate bonds come in a variety of coupon structures:
- Bonds that have a zero coupon rate do not make interest payments. They are issued at a discount to their par value.
- Bonds with a fixed coupon rate pay the same interest rate until they reach maturity, usually on an annual or semi-annual basis.
- Bonds with floating coupon rates are based on a benchmark, such as the Consumer Price Index (CPI) or the London Interbank Offered Rate (LIBOR). The interest payments rise or fall along with the benchmark.
- Bonds with step coupon rates provide interest payments that change at predetermined times, usually increasing. Most have a call provision, meaning that the initial interest rate is paid until the call date. When the call date is reached, the issuer may either call the bond or hike the interest rate.
Disadvantages of Corporate Bonds
Credit risk is a disadvantage of corporate bonds. If the issuer goes out of business, the investor may never get the promised interest payments or even get their principal back.
Corporate bonds are generally considered riskier than government bonds because governments have the option of raising taxes to meet their obligations.
Rating Risk
That said, investment-grade bonds, corporate or government, are considered relatively safe investments. Bonds are rated by three competing agencies: Standard & Poor's Global Ratings, Moody's, and Fitch Ratings. There are other rating agencies, some of them specializing in particular industries.
Their rating systems vary a bit in the details, but generally, any bond rated under B+ is not investment grade.
The Securities & Exchange Commission (SEC) notes that all bond ratings have a potential conflict of interest: The rating agencies are paid, either by the entity issuing the bond or by subscribers to a site for bond investors.
A corporate bond's credit rating is a judgment of the company's creditworthiness. There are some risks that cannot be foreseen.
Event Risk
Another notable disadvantage of corporate bonds is event risk. Companies can face unforeseen circ*mstances that undermine their ability to generate cash flow. Interest payments and repayment of principal depend on an issuer's ability to generate cash flow.
Where Can I Look Up a Bond's Rating?
The rating agencies provide access to their ratings on websites, for free or with a subscription fee.
Media websites including Bloomberg maintain databases of bond ratings.
Online brokers offer their customers access to bond ratings, as do investment advisors.
What Is a Junk Bond?
Investment-grade bonds are relatively safe investments. Junk bonds are not.
A junk bond has a rating of BB or lower from S&P Global, or Ba or lower from Moody's. The rating indicates that the entity issuing the bond is more likely to default than an entity that gets a higher rating.
Junk bonds promise a higher return for investors willing to take the risk.
Many exchange-traded funds (ETFs) and mutual funds focus on junk bond investing. These may be described as "aggressive" or "high-yield" bond funds.
Why Are Bonds Traded?
Bonds are issued with an established face value and a set interest rate. That makes it tough to explain why there's a highly active secondary market where bonds are traded.
The reason is that new bonds are issued every day, and the companies and governments that issue them offer better or worse returns to investors depending on current fluctuations in interest rates.
That makes existing issues more or less valuable to bond investors than new issues.
This generally has no impact on the investor who buys a bond and holds it until it matures.
The Bottom Line
Corporate bonds can provide a reliable stream of income. Investors can choose from many kinds of corporate bonds. However, corporate bonds have their own unique drawbacks.
Pros
Tend to be less risky and less volatile than stocks.
Wide universe of issuers and bonds to choose from.
A liquid and active market.
Cons
Lower risk translates to lower return.
Many corporate bonds must be bought over-the-counter (OTC).
Default risk and interest rate risk.
