Investing in Corporate Bonds
The Benefits and Drawbacks of Investing Corporate Bonds for Your Portfolio
For the bond investor, the options can seem overwhelming: corporate bonds, municipal bonds, government bonds, foreign bonds, agency bonds, savings bonds, first mortgage bonds, debentures; the list seems endless. In this article, we'll walk you through some of the basics of the first item on that list, corporate bonds. Namely, what they are, what determines the interest rate you are likely to receive if you own one, and the types of accounts that are likely the best fit for corporate bond investments.
While this asset class is not for everyone, it does have its place in the portfolio of the right person or institution.
What Are Corporate Bonds?
When you buy a corporate bond, you are lending money to the business that issued it in exchange for interest payments. The company may use this money to build new factories, change its capitalization structure to generate higher returns on equity, acquire competitors, invest in product expansion, refinance old debt, or a host of other things the board of directors and management think are a good idea.
For newly issued, simple, plain-vanilla bonds without any special provisions or unique structure, you will give up cash equal to the par value of the bond. On the future maturity date, that money will be returned to you, and the bond will cease to exist. In the interim, you will receive annual interest income equal to the coupon rate the bond carries.
In the United States, it is often customary for corporate bonds to split the coupon equally into two payments, received every six months, so bondholders don't have to wait a full twelve months before getting some passive income.
What Determines the Interest Rate on Corporate Bonds?
When you invest in corporate bonds, the interest rate you receive depends upon several factors that include, but are not limited to:
- The base opportunity cost bond investors have at the moment - This is often considered to be the yield on a comparable U.S. Treasury bond.
- The maturity date - The longer an investor has to wait to receive the bond principal back from the corporation that issued the bond, the higher the interest rate he or she is going to demand in most cases. There are some rare exceptions that happen infrequently (known as an "inverted yield curve").
- The corporate credit quality of the bond issuer - A bond represents a promise that the corporation will repay you, the lender. If the company goes bankrupt, you might not get your money returned to you, either in whole or part. Stronger companies, with strong balance sheets and income statements, are going to have cheaper borrowing costs than riskier businesses with more leverage or declining sales.
- The inflation rate - When the inflation rate is running high, bond investors will demand that corporate bonds yield more, so they don't lose purchasing power.
- The tax rate applied to the interest stream - Not all bonds are taxed the same. The Federal, State, and local governments will often give certain bonds advantages, such as tax-free status, that allow investors to pay more for them while still receiving the same net income. To make an apples-to-apples comparison, you must calculate something known as the taxable equivalent yield.
- Macroeconomic factors - If the world is experiencing the threat of a nuclear holocaust or a nation is on the brink of being invaded; corporate bond prices are going to collapse. This will send bond yields through the roof because investors think that the probability of not receiving payment is much higher, or they want to grab as much liquidity as they can to have on hand for their family.
- The price you pay - This is especially true if you are buying a bond in the secondary market (from another investor instead of at the time of issuance). This is a more difficult topic that would require its own explanation, but suffice it to say that it's possible to earn more or less than the coupon rate - sometimes substantially - depending on the price you pay to purchase a bond. During depressions and recessions, enterprising investors with large cash reserves have been able to swoop in and buy high-grade corporate bonds at very lucrative yields, locking in paydays that continue for decades.
The chart below illustrates the corporate bonds yields of Moody's Aaa versus Baa.
Which Accounts or Investors Are Going to Be the Best Fit for Corporate Bonds?
Corporate bonds are fully taxable at the Federal, State, and local levels. This means that the bottom-line net interest income yield is going to be different for practically everyone, depending upon your marginal tax rate and location. This also means that corporate bonds, which typically yield much higher than Treasury bonds and municipal bonds, are a natural fit for tax shelters such as a Roth IRA, Traditional IRA, 401(k), 403(b), SEP-IRA, or pension plan. In fact, for investors who don't want to deal with bond funds, corporate bonds are a natural fit; you should never hold tax-free municipal bonds in these accounts due to the fact that the complexities of the tax code will almost always result in you earning far less interest income from your holdings than you could otherwise enjoy.
In contrast, a high-income, successful investor owning corporate bonds through a regular brokerage account, and who lives living in a state that taxes bond interest (almost all of them do), will see practically all of his interest income taken from him once Federal taxes, state taxes, local taxes, and inflation are deducted from his or her returns. Sometimes this is tolerable because there are other reasons to own corporate bonds besides the interest income, especially if there is a lottery ticket attached in the form of a conversion privilege that gives you the opportunity to turn the bond into common stock on attractive terms.