The Basics of Investing in Corporate Bonds
Corporate bonds are simply bonds that are issued by corporations to fund their operations. A company that wants to raise cash can either sell a share of itself by issuing stock or take on debt by issuing bonds. For example, Acme Corp. issues a 20-year bond with an issue size of $10 million, which provides it with cash it can use to build a new factory, open new store locations or otherwise promote growth or fund its ongoing operations.
Investors, in turn, purchase corporate bonds because they typically offer higher yields than are available in government issues.
Corporate bonds have made up between 18 and 20% of the total U.S. bond market in recent years, but many actively managed funds have held much higher weightings in the environment of ultra-low yields on government bonds.
Valuing Corporate Bonds
Investors typically evaluate corporate bonds by looking at their yield advantage, or “ yield spread," relative to U.S. Treasuries. (Treasuries are 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 – think Microsoft, Exxon, etc. – can typically offer bonds with lower yields since investors are confident that the companies won’t default (i.e., miss interest or principal payments).
Conversely, lower-rated companies (those with higher debt or businesses that produce 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 lower risk/lower yield or higher risk/higher yield based on their objectives. From 1996 through 2012, the investment-grade corporate bond market averaged a yield advantage of 1.67 percentage points over U.S. Treasuries.
Investors can also choose among short-, intermediate- and long-term corporate bonds.
Short-term issues typically pay lower yields on the idea that there is a much lower likelihood that a company would default in a three-year period (where there is more certainty) than it would over a 30-year period (where investors have much less visibility into the future). Conversely, longer-term bonds offer higher yields, but they also tend to be much more volatile.
Investment managers seek to add value for their clients along this spectrum, combining bonds of different maturities, yields, and credit ratings in order to achieve the optimal combination of risk and return.
How Risky are Corporate Bonds?
Corporate bonds, as a group, have experienced a very low incidence of default over time. Higher-rated bonds, in particular, have a very low chance of default. In the period from 1920 through 2009, bonds with the highest credit rating – AAA – defaulted less than 1% of the time. As a result, investors in individual bonds can reduce their risk by focusing on the highest rated issues.
Bond funds and exchange-traded funds (ETFs) have a different set of risks because, unlike individual bonds, there is no fixed maturity date. Two factors that can affect the performance of corporate bond funds are:
- Prevailing interest rates: Since corporate bonds are priced on their “yield spread” versus Treasuries, movements in government bond yields have a direct impact on the yields of corporate issues. For example, a corporate bond yields one percentage point more than Treasuries, and the yield on the 10-year note rises from 2% to 3%. The yield on the corporate bond will also have to rise by one percentage point in order for the spread to stay the same. Keep in mind, prices and yields move in opposite directions.
- Investors’ overall perception of risk: While favorable headlines make investors more willing to take on added risk to hold corporate bonds, disruptions in the global economy can cause market participants to become more risk-averse and prompt them to seek safer investments, such as government bonds or money market funds.
The Performance of Corporate Bonds
Over time, corporate bonds have offered investors attractive returns for the attendant risks. In the three-, five- and 10-year periods ended Dec. 31, 2013, the Barclays Corporate Investment Grade Index had provided average annual total returns of 5.36%, 8.63% and 5.33%. In the same period, the broader investment-grade bond market – as measured by the Barclays Aggregate U.S. Bond Index – returned 3.26%, 4.44% and 4.55%.
How to Invest in Corporate Bonds
There are two ways to invest in corporate bonds. First, investors can purchase individual corporate bonds through a broker. Those who opt for this route should have the ability to research the issuing companies’ underlying fundamentals to ensure that they don’t purchase a bond at risk of default. Also, an investor in individual corporate bonds should ensure that their portfolio is adequately diversified among bonds of different companies, sectors (i.e., technology, financials, etc.) and maturities.
The second 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, as outlined above, they also have the benefit of diversification and professional management. Investors can use tools such as Morningstar or xtf.com to compare funds and mutual funds, respectively. Investors also have the option of investing in funds that focus exclusively on corporate bonds issued by companies in the developed international markets and the emerging markets. Although these funds have more risk than their U.S. counterparts, they also have the potential for higher longer-term returns.
The Bottom Line
The corporate bond arena offers investors a full menu of options in terms of finding the risk and return combination that suits them best. Corporate bonds are therefore a core component of diversified, income-oriented portfolios.