The main idea behind corporate bonds is quite basic. Corporations need funds in order to maintain their operations and as such, they issue bonds. When investors buy a bond, they are lending money to the entity that issued the bond. The bond is a promise to repay the face value of the bond (the amount loaned) with a specified interest rate within a specified period of time. Therefore, in a way, a bond can be said to be an I.O.U. There are essentially two ways a company can raise cash: the company can either sell a share of itself by issuing stock or take on debt by issuing bonds.
For instance, ABC Corp. issued a 15 year bond with an issue size of $10 million, which provides it with the cash that it needs to build a new factory, open new store locations, or otherwise promote growth or fund its ongoing operations. Investors purchased the corporate bonds that ABC Corp. issued because they typically offer higher yields than usually safer government issues.
Corporate bonds have historically constituted between 18 and 20 percent of the total U.S. bond market, but many actively managed funds have held much higher weightings in the environment of ultra-low yields on government bonds than the aforementioned 18 to 20 percent.
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Benefits of Investing in Corporate Bonds
Investing in corporate bonds comes with a lot of benefits. Some of them include;
- Mouthwatering yields: There are several types of bonds available for investors to consider. Corporate bonds are known to offer better yields when compared to government bonds or CDs. But like with most investments, the higher yield means that it comes with greater risks.
- Diversity: Corporate bonds provide an opportunity to choose from a variety of sectors, structures and credit-quality characteristics to meet your investment objectives.
- There are a variety of bonds that you can take advantage of: there are many types of corporate bonds that are available both in the primary and also the secondary market. Some of them mature in a period of 5 years while some take less time in order to attain full maturity. Others may mature at 12+ years. Some long-term bonds may have 20-year or 30-year maturity dates. There are fixed coupon rates that pay the same interest rate, usually annually, but some may offer twice-per-year payments. Step coupons allow the interest rate to change at predetermined times.
- Safety: Corporate bonds are evaluated and assigned a rating based on credit history and ability to repay obligations. The higher the rating, the safer the investment as measured by the likelihood of repayment of principal and interest.
- The payments of a corporate bond are structured: Corporate bonds offer a structured compensation plan for investors, and as such, it can provide a reliable source of income. Even though the returns of a corporate bond may not always be competitive to the returns of stocks or mutual funds, there is a reliable schedule of income to depend upon, which can then be used for making future investments. When relying on disbursements or dividends for this income, there are fewer guarantees.
- Pricing structures for corporate bonds are consistent: You can purchase corporate bonds through public offers or security exchanges. These are referred to as the primary market and secondary market for bonds respectively. You’ll still receive a prospectus when purchasing corporate bonds privately and apply for a direct purchase. Many of these bonds, including private ones, can be sold on a securities exchange after they have been issued. There are fewer fluctuations in the pricing structure, which helps to stabilize a portfolio.
- Marketability: it is easy to sell your bonds before the mature because of the size and liquidity of the market.
- Bond holders are classified as creditors and rank higher in subordination: in the event that a business should pack up or become bankrupt, the shareholders may not be able to make a claim on their investments in the company. Corporate bonds on the other hand is classified as a debt and as such, it gives the holder the status of a creditor. They often rank higher than other creditors when assets are being distributed during a bankruptcy proceeding. In such a situation, the bond holder may not make a profit, though they have a better chance to recover some of their initial investment.
- Some corporate bonds may be converted into stocks: an option that is used by corporations to repay investors who purchase corporate bonds is to offer those investors stocks in lieu of cash payments. This may be part of the initial agreement during the investment. It may also be an option permitted as a way to improve the cash liquidity of a business that may be attempting to restructure its debt. If this should happen, the stocks can then be sold out in the secondary market easily and at the current value of the stock. Under the right circumstances, investors could see a bigger return with this option.
- They offer a predictable source of income: Most corporate bonds offer a predictable schedule for their payments, which allows you to plan in advance for the payments which will be received. An investment product, like a bond fund, may offer payments more frequently, though the payments are also more unpredictable.
Disadvantages of Corporate Bonds
Even though investing in corporate bonds comes with a lot of merits, it is not without its shortcomings. Some of them are discussed below.
- Corporate bonds rarely provide capital growth: by design, bonds were not created with the intention of increase in value during the time they are held. Even though some may increase in value (or decrease) on the open market due to changing economic conditions, the goal of a bond is to provide structured interest payments while returning the principal to the investor over time.
- Bonds can be defaulted on: even though it has been said that corporate bonds comes with less risks, this does not mean that they are totally devoid of risks. Corporations may sometimes default on their bonds because they no longer have the ability to pay their bills. When this is the case, there may be few options for a bond holder to recover their initial principal. Unlike other forms of debt that are taken on, the prospectus outlines the potential risks of the investment to each investor. If the company just goes out of business, it may be difficult to recover funds.
- It is a financial resource that can be difficult to sell: although corporate bonds can be resold to others, the economic conditions must be almost perfect for that to happen for an investor. That is because other investors want to make a profit off the investment, which means the initial investor would need to take a loss on the transaction. The only way for the initial investor to make a profit, plus give a discount on the sale, would be to have interest rates rise enough on bonds to make that happen.
- Secondary markets have fewer buyers than primary markets: due to the repayment structure of a corporate bond, there may be zero buyers in the secondary market for some bonds. In the event that an investor would like you to add these bonds to his or her portfolio, they would be forced to look at the primary market, review each prospectus, and make the best possible choice from available options. That process requires a time commitment which some investors may not have.
- It relies on interest rate stability for profitability: Corporate bonds are based on the current interest rates that are available within their market. For instance, if the interest rate is at 1%, then it will continue to be at that percentage throughout the life of the bond. If interest rates rise during the repayment period of the bond, then the profits available to the investor becomes less. In some extreme situations, interest rate changes can be dramatic enough to eliminate any profitability from the corporate bond, forcing the investor to hold onto a product until it reaches the end of its life.
- A larger investment is required to purchase a corporate bond: The minimum purchase amount for a corporate bond depends upon the issuer and as such investing in corporate bonds may not be for everyone. Although some corporate bonds may be issued for as little as $1,000, some corporate bonds may have a required minimum buy-in of $25,000 or even more! Those investment minimums do not apply to stocks, where an individual can purchase a single share at the market rate if they wish. That structure gives some low-level investors fewer opportunities to get involved in this process.
- Bonds require you to ladder your portfolio: in order to make sure that your corporate bonds are an effective income source, you must do more than manage the risks of each investment. You must also ladder your portfolio to have different bonds with different maturity dates. Then you must record each interest check when it comes in, deal with situations when a bond is called by the company, and the potential tax complications which occur with each action.
- Payments are infrequent for bonds: Most corporate bonds will only pay once per year. If an investor were to look at bond funds instead, there is a good chance that monthly payments would be received instead. Even high-dividend stocks would likely offer 4 payments per year instead of just one. For investors who require frequent deposits to take care of their daily expenses, corporate bonds may not offer the flexibility that is required.
Investing in Corporate Bonds
There are two major ways to invest in corporate bonds:
- Investors can purchase individual corporate bonds through a broker. If you would like to tow this path, you should do well to research the issuing companies’ underlying fundamentals to ensure that they don’t purchase a bond at risk of default, which although somewhat rare, should remain firmly on the checklist. An investor in individual corporate bonds should ensure that their portfolio is adequately diversified among bonds of different companies, sectors (i.e., technology, financials, et al), and maturities.
- Another option is to invest via mutual funds or exchange traded funds (ETFs) that focus on corporate bonds. Although funds have a different set of risks than individual bonds, they also have the benefit of diversification and professional management.
There are tools such as Morningstar or xtf.com that are available to investors which they can use to compare funds and mutual funds. Investors also have the option of investing in funds that focus exclusively on corporate bonds issued by companies in the developed international markets and emerging markets. Although these funds have more risk than their U.S. counterparts, they also have the potential for higher longer-term returns.
Corporate Bonds that are rated triple A (AAA) are the most reliable and the least risky to invest in; bonds that are rated triple B (BBB) and below are the most risky. Bond ratings are calculated using many factors including financial stability, current debt and growth potential.
In a well- diversified investment portfolio, highly-rated corporate bonds of short-term, mid-term and long-term maturity (when the principal loan amount is scheduled for repayment) can help investors accumulate money for retirement, save for a college education for children, or to establish a cash reserve for emergencies, vacations or for other expenses.
Usually, investors evaluate corporate bonds by looking at their yield advantage, or “yield spread,” relative to U.S. Treasuries. Treasuries are considered the benchmark, since they are seen as being completely free of default risk.
Highly rated companies that are financially strong and have massive amounts of cash on their balance sheets such as Apple, Google, Exxon et al.—can typically offer bonds with lower yields since investors are confident that the companies won’t default (that is, miss interest or principal payments).
On the other hand, lower-rated companies (those with higher debt or businesses with unreliable revenue streams) have to offer higher yields to entice investors to purchase their bonds. Investors, in turn, make the choice along the spectrum of owner risk and lower yield or higher risk and higher yield based on their objectives. It’s the classic risk-reward scenario investors consider as they research investments.
Investors can also choose among short, intermediate, and long-term corporate bonds. Short-term issues typically pay lower yields, based on the idea that a company is much less likely to default in a three-year period (where there is more certainty) than over a 30-year period (where investors have much less visibility into the future). Conversely, longer-term bonds offer higher yields, but they tend to be much more volatile.
Investment managers seek to deliver above-average returns along this spectrum, combining bonds of different maturities, yields, and credit ratings in order to achieve optimal profits while mitigating risk.
Considerations to Have in Mind When Investing in Bonds
When deciding to invest in bonds, here are some key considerations that you ought to have in mind as they will ultimately help you to make a good and profitable decision.
- Control: Direct bond investment means you decide which companies’ bonds to invest in. While a bond broker might make suggestions about bonds to include in a portfolio, you make the final decision. Direct bond investors know all of the companies in their portfolio and there is complete transparency in this regard.
If you invest directly, you can build a portfolio that suits your investment goals whether these are based around low risk, high return or the delivery of a monthly cash flow. You also then make the decisions on when to buy, sell or hold, depending on your needs. Bonds, like managed funds can be sold down in small parcels providing liquidity if needed.
On the other hand, if you invest in a managed fund then someone else makes the decisions about what to invest in, when to buy and sell and when to make distributions to investors. They don’t know what you already have in your portfolio, so if you have significant allocations to some sectors, these may be increased through managed fund investments.
You’ll need to decide if you want a passive fund (where there is no or little oversight) and the fund aims to beat a benchmark or an active manager that oversees the portfolio. The distinction is often reflected in the fees, where higher fees are charged for active management. Returns for active funds can significantly outperform passive funds, but this is not always the case.
In a low interest rate environment, it’s much harder for actively managed funds to outperform after higher fees are deducted. Some investors prefer not to invest in certain sectors for ethical or environmental reasons or just because they don’t think the sector is worth investing in. Direct investing allows for that kind of flexibility.
2. Time and confidence: If you would like to make a direct investment to corporate bonds, then you will need to take your time to study and understand how this asset class works. Those wanting to invest directly need to take the time to learn about the asset class. If you don’t have the time or perhaps don’t yet have the confidence, managed funds may suit you better.
3. Those with less than $250,000 to invest in bonds: You need a minimum of $250,000 to invest in direct bonds. The minimum amount per bond is $10,000 which means you can buy 25 individual bonds. Being able to trade bonds through a dealer/ broker gives you distinct advantages which include access to expert opinion on which bonds represent good relative value, access to new originated bonds, not available elsewhere, research and the opportunity to build relationships. For those with less than $250,000 to invest, a corporate bond fund is a good place to start.
It is of utmost importance that you have a good understanding of what you are putting your money into. Don’t make the assumption that all funds are diversified. A fund like the AMP Corporate Bond Fund is well diversified with the top 10 holdings representing just 22% of the fund. But there are others such as the Russell Investments Australian Select Corporate Bond ETF with 76% of its holdings invested in the bonds of the ‘big four banks’ and its only other holding is Telstra. There is very little point using such a fund if your objective is diversification.
4. Transparency fees: Most managed funds do not disclose more than their top ten investments. This means you don’t know what they have invested in. Fund managers usually do not want competitors to know what’s in their portfolios but this makes it very difficult for investors to analyses the risk of the fund. Direct ownership means you know precisely what you own and can determine if the risk is appropriate for your circumstances.
5. Diversification across your portfolio: If you own a lot of bank stocks or residential property, one thing to watch with a corporate bond fund is the level of bank exposure. Most of the large corporate bond funds have a very high (20%+ plus) exposure to global banks, which means if you already hold bank shares in your SMSF, you are creating a very high allocation to banks across your whole portfolio. Direct bond ownership means you can tailor your bond portfolio to fit in with the rest of your portfolio.
In conclusion corporate bonds offer investors a lot of options when it comes to finding the risk and return combination that suits them best. Even though investing in corporate bonds is not without risks and may sometimes even result in the investor running a loss of investments, highly-rated corporate bonds could reasonably assure a steady income stream over the life of the bond. It only makes sense to have a corporate bond if you would like to diversify your portfolio.