Investing in bonds can be a great way to get some return on your principal while reducing the risk of capital loss. This is especially useful when you are getting closer to a financial goal and when stock market volatility can lead to large and rapid capital losses.
When it comes to earning the highest yields, corporate bonds often outperform federally issued treasuries and municipal bonds issued by states and local governments.
A corporate bond is a debt security issued by a company to raise funds. Buyers of corporate bonds lend money to the company, while the company has a legal obligation to pay the interest agreed with the bondholders. When a corporate bond matures or matures, the company reimburses the bondholder.
How corporate bonds work
A corporate bond is a loan to a company for a predetermined period, with a predetermined interest yield that it will pay. In return, the company agrees to pay interest (usually twice a year) and then repay the face value of the bond when it matures.
Let’s take a typical fixed rate bond as an example. If you invest $1,000 in a 10-year bond with 3% fixed interest, the company will pay $30 per year and return your $1,000 within a decade.
While fixed-rate bonds are the most common, there are others to consider, including:
- Floating rate bonds, which have variable interest rates that change based on benchmarks such as the US Treasury rate. These are usually issued by companies that are considered below investment grade, i.e. those that are considered junk bonds.
- zero coupon bonds, which do not come with interest payments. Instead, you pay below face value (the amount the issuer promises to repay) and receive full value at maturity.
- convertible links, that give companies the option of paying investors with common stock instead of cash when a bond comes due.
How to buy corporate bonds
In general, there are three ways to buy corporate bonds:
- New number
- Secondary market
- Bond funds
New bond issues are newly offered by a company seeking to raise funds through an intermediary broker-dealer. You will pay the face value and the company will receive the proceeds, net of any fees retained by the brokers for their services.
The secondary market is where you can buy bonds that have already been issued from investors who own them and are looking to sell them before maturity. The price may be higher or lower than face value, depending on interest rates (to keep the yield competitive with the yields paid by new issues), as well as the financial condition of the issuing company. For example, bonds issued by a company that may not be able to meet its financial obligations often trade at a discount to face value in the secondary market. This is to compensate buyers who take the risk that a company may not be able to pay its obligations.
A bond fund allows you to invest in a broad group of bonds, and a number of bond funds invest exclusively in corporate bonds. Individual bonds generally require a minimum investment of $1,000, which could make it difficult for many people to build a diversified bond portfolio. If you’re working with small amounts of money, a bond fund might be ideal since the minimum investment is the price of a single share of an exchange-traded bond fund (ETF). Bond funds have a price. The fund manager has expenses to cover and also wants to make a profit. Make sure you understand the fees you’ll pay – measured as an expense ratio – before investing in a bond fund.
How to make money with corporate bonds
Investing in corporate bonds is generally part of a strategy to protect your capital and benefit from the interest paid within a diversified portfolio of stocks and bonds.
You can also make money by investing in bonds that trade at a discount to face value (also called face value). This can happen for several reasons. One of the reasons is a change in the interest rate environment. If interest rates rise, investors can earn more with new issues, so existing bonds will be discounted to compete with new issues.
A bond may also be downgraded if a company may not be able to meet its obligations or may be forced to issue shares to redeem convertible bonds. In these cases, bondholders are often willing to sell below face value – how much bond investments cost at issuance – to reduce the risk of possible higher losses. There is certainly more risk with bonds in such situations since these companies could default on their debts, resulting in losses for their bondholders.
Corporate bonds vs stocks
Stocks represent direct ownership of a company, while bonds are a loan with a predetermined rate of return. This is why, even for a solid and profitable company, the value of its bonds will remain stable even if the share price changes considerably. You usually know exactly what you’re getting with a bond.
However, a company’s stock price can fluctuate widely and is often based on projections of what people think. could win in the future. As a result, stock prices can be volatile, while corporate bonds tend to hold their value. You trade the upside potential of stocks for the predictability of bonds.
Advantages and disadvantages of corporate bonds
As noted, the biggest advantage of corporate bonds is stability. Bonds tend to hold up in all economic environments as long as the issuing company remains in good shape. Even the stocks of the best companies can crash with the market, and this volatility can lead to big losses if you have to sell at a specific time.
The downside is that this stability comes at the expense of lower long-term returns. Here’s how the SPDR S&P 500 ETF Trust (NYSEMKT: SPY) played in the last decade compared to the Vanguard Long Term Corporate Bond ETF (NASDAQ: VCLT) and the Vanguard Short Term Corporate Bond ETF (NASDAQ:VCSH):
Bottom Line: Corporate bonds are ideal stores of value for the wealth you’ll depend on for the next five years or less. Over longer periods, bonds do not match the wealth-creating power of stock ownership.
Holding corporate bonds also has tax implications. If you hold bonds in a taxable account, Treasury bonds may be the better choice. They may pay a lower yield, but after taxes on corporate bond interest, a tax-free government bond could mean more total after-tax income.
How to choose corporate bonds for your portfolio
Let’s start with credit scores. There are three well-known bond rating agencies: S&P Global (NYSE: SPGI), Moody’s (NYSE: MCO)and Fitch.
In general, the lower a credit rating, the higher the interest rate a company must offer to compensate for higher risk. Corporate bonds rated below BBB- by S&P and Fitch and Baa3 by Moody’s are considered junk bonds. Most investors should avoid junk bonds because the risk of permanent losses is much higher than with higher quality corporate bonds.
In addition to the credit rating, a bond’s interest rate is usually a product of its term. The longer the term, the higher the interest rate. For example:
But don’t just buy bonds with the highest yields on your time frame; be sure to diversify the risk factors. For example, buying only bonds from companies in the same industry or exposed to the same risks could result in a riskier bond portfolio than you think. So think about each bond purchase and how it fits into your portfolio.
Are corporate bonds right for you?
Are you only a few years away from a financial goal? If so, it might be time to start moving your assets away from equity volatility and adding more corporate bonds to your holdings. Remember that, as the chart above shows, corporate bonds have historically underperformed equities over the long term. Too much exposure to bonds too soon can hamper your returns, leaving you with less wealth than you expected.
There is also a psychological aspect to consider. Many investors find it difficult to hold stocks during a market downturn. If owning more bonds reduces the likelihood that you’ll sell stocks in a stock market crash, then owning more bonds than recommended for your age and life stage might be the right decision for you. In this case, the higher yields of corporate bonds relative to Treasuries can help offset the “lost” returns from not owning more stocks.