As the name implies, corporate bonds are issued by companies - usually large, publicly traded ones. The company borrows money from investors to fund business initiatives like buying new equipment or building a plant.
There are four main groups of corporate bonds, divided by sectors: utilities, transports, industrials and financial services. Corporate bonds are also classified by the type of asset which serves as collateral to secure the loan, such as mortgages, financial obligations, machinery equipment, etc. Corporates without any specific collateral are known as debentures. Corporate debt can be further subdivided by seniority. In the event of default, corporate bonds issued as “senior bonds” are higher in the pecking order of folks getting paid back than “subordinated” or “junior bonds”.
If you’re shopping for bonds to round out your asset allocation, corporates involve more risk than munis or Treasuries - but that increased risk is usually counterbalanced by a higher interest rate. If your risk tolerance can stand a bit more rock n’ roll factor, corporates might make sense for part of your bond allocation. Corporate bonds involve more risk for several reasons; chief among them are event risk, credit risk, default risk and call risk.
Event risk refers to the possibility that the issuing company could become a take-over target of another company. If a takeover occurs, the terms of the target’s debt may be changed significantly, often to the detriment of its bondholders. This is known as restructuring, which can cause bond prices of the affected issues to fall sharply. This may also result in credit downgrades, which would then further negatively impact a bond’s price.
Credit ratings help investors quantify some of the risks involved with a particular bond. However, evaluating credit risk is more complex for corporates than for munis. Besides analyzing the specific type of bond involved and the issuer’s credit-worthiness, there are several other factors to consider: the trends within the issuer’s sector, whether the corporation is among the best of breed for its particular sector, the quality of the management team, and the overall economic environment. Although credit ratings provide insight into the risks you take on when purchasing bonds, you should consider these other factors, too. If you feel uncertain about the issuer’s core business or the wider business or economic environment, don’t just take the credit rating for granted. These are only a guide and can change over time. Take the extra steps needed to do your own research.
The issuer defaulting is the worst-cast scenario for a bond holder. Default can impact your bond investments in two different ways. First, the coupon payments would either be temporarily suspended or cease entirely. The second, and far worse, is if an issuer cannot return face value at maturity to bond holders as promised. Of course bond holders have legal means to collect repayment from the issuer if in default. However, doing so is no easy matter. Even if you are able to collect payment, you’ll likely receive only pennies on the dollar and not the full value invested.
Although not guaranteed, corporate bonds rated investment-grade or higher have a low chance of default. The rate of default is much higher for high-yield bonds, fittingly referred to as “junk bonds”. These investments should be avoided except for well-capitalized, very advanced and extremely savvy fixed-income investors who can handle the considerable risks involved.
Besides dealing with several kinds of risk, corporate bonds involve more complex provisions (fine print) than munis. In addition to somewhat common clauses like call and put features, corporate bonds may have equity components, floating coupons, or other unique features. Review them carefully before investing and be sure you understand every aspect of any fixed-income security before buying.
Corporate bonds are fully taxable at the federal, state and local levels - a chief difference between this kind of bond and munis or Treasuries. This is another reason corporates usually generate higher interest payments than these potentially tax-exempt bonds. That doesn’t automatically mean corporates are a sweeter deal when all’s said and done. Assuming all other risk factors are equal, when comparing yields, be sure to do so on an after-tax basis.
You might opt to invest in corporate bonds if:
- Bonds are a part of your asset allocation plan. You’ve decided to invest a certain percentage of your portfolio in bonds.
- You’d rather receive a higher rate of interest than a tax break since corporate bonds are fully taxable.
- You’re willing to take on more risk for a higher return. Corporates entail more risk than munis or Treasury bonds.
- You already know (and believe in) a public company that also issues bonds. If you already know a winning stock well, you might use that knowledge to allocate a portion of your fixed-income assets towards the same company’s bonds.
- You want a liquid market for your bond purchases and sales. Corporate bonds issued by large, publicly traded companies are usually more liquid than compared to munis.
Laddering is a bond strategy that spreads your risk over a series of different maturities, while maintaining an average maturity that suits your investment goal’s time horizon.
Your time horizon may vary according to your investment objectives, asset allocation, risk tolerance and available capital. Try to choose a bond with a maturity date that coincides with when you expect to need the money.
Some investors gradually shift from higher-risk investments like stocks to high-quality, investment-grade corporate bonds as the time horizon for a given financial goal approaches.
When to Get In
You might buy corporate bonds if:
- You expect interest rates to decrease in the future.
- You want to transition assets into corporates as your time horizon for reaching a financial goal approaches.
- You are super-nervous about the stock market.
- You don’t have a clear outlook on the market as a whole.
When to Get Out
Corporate bonds are usually purchased with the intention of holding them until maturity. That said, you might liquidate your holdings if:
- You expect interest rates to increase.
- You are concerned about the financial health of the issuer, its sector, or the larger business environment, well in advance of a negative credit rating change.
- You are comfortable with the risk-reward relationship offered by the stock market.
- You have a clearer outlook on the stock market.
- You need the money for a specific purpose.
- The bond reaches its maturity date.
Corporate bonds are usually purchased with the intention of holding them to maturity. However, these bonds are not without risk. In addition to monitoring the bond’s credit rating, you may wish to track the company through research reports, annual filings, and news events. Keeping tabs like this may provide insight into the issuer’s financial health and therefore credit-worthiness. Monitoring its sector or industry may also keep you ahead of the curve and alert you if troubled times are ahead. If you just wait for the credit rating to be negatively affected, it will likely be too late to minimize your potential losses. Staying on top of the factors that influence credit ratings allows you to adjust your holdings accordingly, if necessary, before the crowd.
Corporates are oftentimes subject to call provisions or may be riddled with other fine print clauses that should not be ignored. In the case of munis, falling interest rates are the main factor that might trigger the issuer to call its bonds back. For corporates, there are many other reasons why an issuer would call a corporate issue, usually because the issuer can obtain debt financing for a lower cost. If this is the case, it will likely exercise its right to call the bond issue, or portions of the issue. You’ll need to monitor your corporate bond investments closely, on an ongoing basis, as interest rates and the market environment changes. At times it may be prudent for you to sell your bond in the secondary market if it seems a call is imminent. If this is the environment you find yourself in, be ready to find a new investment for the your principal. Ignoring the fine print may result in losses that could be preventable. The specifics of these clauses can be complicated and are beyond the scope of this article. Be sure to research any investment carefully before purchase.
The interest payments you receive while holding corporate bonds also deserve your attention. Each individual coupon payment may not seem like much money. However, stashing these payments in a savings account over the course of a year can mount to a nice chunk of change. Possibly consider reinvesting these funds to purchase additional bonds on an annual basis.
Among the three bond types, corporate bond prices tend to fluctuate the most, since they involve the most risk. Fluctuation in bond prices is a factor of changes in interest rates and changes in credit quality. If you hold your bonds until maturity, the volatility they experience between now and then doesn’t change the fact that you will receive the full face value at that time, barring default. However, tolerating this volatility as it occurs may be easier said than done. Be sure to choose a corporate bond investment that is inline with your risk tolerance. Increased time-to-maturity, higher coupons, longer duration, illiquidity and bonds trading at a discount are all additional factors which can increase the volatility of bond prices.
TradeKing Margin Requirements
After the trade is paid for, no additional margin is required. Investment-grade corporate bonds are rarely available for margin. Check with our trade desk for details.
Investments in corporate bonds are fully taxable at the federal, state and local levels. Consult your tax advisor for the low-down on this important topic.
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