The idea of corporate bonds is simple: Corporations issue bonds to fund their operations. There are two basic ways for a company to raise cash. It can sell a share of itself by issuing stock; or, it can take on debt by issuing bonds.
For instance, let's say Acme Corp. issues a 20-year bond with an issue size of $10 million. This provides it with the cash it needs to build a new factory. It can also open new stores, promote growth, and fund its operations. Investors purchase the bonds because they often offer higher yields than government issues.
Corporate bonds have historically made up 18 to 20% 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.
How Can You Invest in Corporate Bonds?
There are two ways to invest in corporate bonds. First, you can purchase individual corporate bonds through a broker. Those who opt for this route should research the issuing company's fundamentals. You need to be sure you aren't buying a bond at risk of default. Though this is fairly rare, it should remain firmly on your checklist.
If you invest in individual bonds, you want to ensure your portfolio is diversified enough. This should include bonds of different companies, sectors, and maturities.
The second option is to invest via mutual funds or exchange-traded funds (ETFs) that focus on corporate bonds. Funds have a different set of risks than bonds. But they also benefit from diversification and being professionally managed.
You can use tools such as Morningstar to compare funds and mutual funds. You also have the option of investing in funds that focus only on corporate bonds issued by companies in developed and emerging foreign markets.
These funds have more risk than their U.S. counterparts. But they also have the potential for higher longer-term returns.
How Can You Evaluate Corporate Bonds?
Corporate bonds are often evaluated by looking at their yield advantage, or “yield spread," relative to U.S. Treasurys. Treasurys are considered the benchmark. That's because they are seen as being free of default risk.
Highly-rated companies can offer bonds with lower yields. They are financially strong and have massive amounts of cash on their balance sheets; these firms include Microsoft, Amazon, and Exxon. You can feel certain that these highly-rated firms won’t default by missing interest or payments.
On the other hand, lower-rated companies have to offer higher yields to entice people to purchase their bonds. These are firms with higher debt or less reliable revenue streams. Investors, in turn, make a choice along the spectrum of lower risk and lower yield; or, higher risk and higher yield. It's all based on their objectives. This is the classic risk-reward question you'll have to think about as you do your research.
Investors can also choose between short, intermediate, and long-term corporate bonds. Short-term issues often pay lower yields. This is based on the idea that a company is much less likely to default in a three-year period than over the course of 30 years. That's because three years is a more certain timeframe than 30 years. 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. They may combine bonds of different maturities, yields, and credit ratings. This can help to achieve optimal profits and still mitigate risk.
What's the Risk With Corporate Bonds?
Corporate bonds have seen a low incidence of default over time. Higher-rated bonds, in particular, have a low chance of default. Since 1981, bonds with the highest credit rating, AAA, have had an average default rate of 0%. As a result, you can reduce your risk by putting your focus on the highest-rated individual bonds.
Bond funds and exchange-traded funds (ETFs) have different risks. Unlike individual bonds, there is no fixed maturity date. There are two factors that can affect how corporate bond funds perform. They are:
- Prevailing interest rates: Corporate bonds are priced on their yield spread vs. Treasurys. This means movements in government bond yields directly impact corporate issues. The yield on the corporate bond will also have to rise by one percentage point for the spread to stay the same. Keep in mind that prices and yields move in opposite directions.
- Investors’ perception of risk: Favorable headlines make investors more willing to take on added risk to hold corporate bonds. But global events can cause investors to become risk-averse. Each person has to choose their own comfort zone on the risk and reward spectrum. Such global news could prompt some to seek safer investments; these could include government bonds or money market funds.
The Bottom Line
Over time, corporate bonds have offered strong returns. There is not much deviation from those returns across the smaller ETFs; returns like that are very low, even when taking risk into account.
The corporate bond arena offers a full menu of options in terms of finding the risk and return combination that suits you best. Corporate bonds are a core part of a diverse, income-oriented portfolio.