Corporate Bonds
Investors buy corporate bonds for various reasons: attractive and predictable returns, dependable income, flexibility, and diversification. Corporate bonds are debt obligations issued by U.S. and foreign companies to raise capital for business growth and general corporate purposes. Most are unsecured promises to repay the principal at a predetermined future date, although some bonds may be secured by a first mortgage or other assets. The issuing company also agrees to pay interest to compensate investors for lending their money. Unlike stocks, which represent ownership in a company, bonds are obligations of the issuer to pay back the borrowed funds. Hence, the bondholders have priority over the stockholders to be paid interest and principal prior to any dividend distributions.
BENEFITS OF CORPORATE BONDS
Predictable Income – Most corporate bonds offer fixed interest payments for the life of the bond, which may be paid semi-annually, quarterly, monthly or at maturity. The interest rate and payment frequency are set at the time of issuance so investors always know when and how much to expect. This is especially beneficial for retirees and other investors looking to supplement their current income. Like many other fixed income investments, corporate bonds offer various coupon structures to suit the individual investor’s cash flow needs.
Competitive Returns – Since corporate bonds are considered riskier than other fixed income investments, such as Treasury bonds, they generally offer higher yields. In addition, yields vary among corporate bond issuers based on different risk factors, including an issuer’s creditworthiness and its industry. Economic factors and changing market conditions may have a greater effect on some industries than others. Corporations and industries perceived to have more risk will have to offer higher yields to gain access to capital markets. Corporate bonds present investment opportunities for many levels of risk tolerance. Therefore, investors and their advisors should carefully examine each bond’s characteristics to determine if a higher yield is worth the extra risk. Investors willing to accept higher risk may benefit from potentially higher returns.
Flexibility – There are three general maturity categories for corporate bonds: 1. short-term – up to five years; 2. medium-term – five to 12 years; and 3. long-term – greater than 12 years. Although longer-maturity bonds may offer higher rates, their prices tend to be more sensitive to changes in interest rates. Investors with short investment horizons should not buy long-term bonds, as proceeds from sale prior to maturity may be less than the original investment.
Survivor’s Option – Some corporate bonds offer an estate protection feature, which allows an estate, upon evidence of death of the bondholder, to redeem bonds from the issuer at par plus any accrued interest. Limitations vary by issuer and may limit the total redeemable amount per bondholder per year, as well as the total redeemable amount per issuer per year.
Liquidity – Although not obligated to do so, many broker/dealers participate in the secondary market for corporate bonds. Investors who need access to cash may sell their bonds prior to maturity, at current market prices. In the secondary market, trading timeliness and prices are subject to market interest rates, issue and position size, credit rating, and other factors. Some bonds trade more often than others and may be easier to sell. The proceeds from sale may be more or less than the original investment. However, if bonds are held until the final maturity date, the investor will receive the full face value, subject to credit risk.
In order to improve market transparency, the Financial Industry Regulatory Authority (FINRA) created TRACE – Trade Reporting and Compliance Engine. Investors can access historical data on market transactions for publicly traded securities, including corporate bonds, at investinginbonds.com.
Taxation – Interest income from corporate bonds is generally subject to federal, state and/or local taxes. Investors who decide to sell bonds before the final maturity date may incur capital gains or losses and are advised to consult a tax advisor to ensure proper tax reporting.
DIVERSIFICATION
Diversification is a time-tested strategy to help stabilize portfolio returns and meet specific investment objectives. However, diversification does not ensure a profit or protect against a loss. Corporate bonds come with a wide range of maturities, payment frequencies, coupon structures, credit ratings and other features, such as calls and survivor’s option. Bonds are issued by companies in many industries – from finance to healthcare to transportation. Choosing investments from different industries and issuers is important as they may behave differently in changing economic and market environments. Bond investors should monitor rating agency updates as well as company and industry news, and adjust their portfolios accordingly.
Corporate bonds are most suitable for investors who are interested in a fixed rate of return and relative safety of principal, subject to the credit worthiness of the issuer. Various bond structures are available in the market and not all offerings may be suitable for every investor.