How to Invest in Corporate Bonds: The Basics
The idea of corporate bonds is incredibly simple: Corporations issue bonds to fund their operations. There are essentially two ways for a company to raise cash—it can 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 the cash it needs to build a new factory, open new store locations, promote growth or fund its ongoing operations. Investors purchase the bonds because they typically offer higher yields than usually safer 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.
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, which although somewhat rare, should remain firmly on the checklist.
An investor in individual corporate bonds should ensure their portfolio is adequately diversified among bonds of different companies, sectors such as technology or financial, 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, 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. 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.
Investors typically 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—Microsoft, Amazon, Exxon—can typically offer bonds with lower yields since investors are confident that the companies won’t default (that is, miss interest or principal payments).
Conversely, 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 lower 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.
Corporate bonds have generally experienced 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, 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 directly impact corporate issues. 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 that prices and yields move in opposite directions.
- Investors’ 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 risk-averse, prompting them to seek safer investments, such as government bonds or money market funds.
Over time, corporate bonds have offered investors attractive returns for the relevant risks. There is not much deviation from those returns across the smaller ETFs, and returns like that are considered exceptionally low, even when factoring in risk.
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.