Corporate bonds can provide investors with access to yield, sometimes with less risk
Default risk does exist, so it can help to approach corporate bonds with caution
There are ways to measure potential risk with corporate bonds
In late 2018, struggling General Electric (GE) announced it would slice its quarterly dividend from 12 cents to just a penny a share. GE investors who wanted those regular payments had a choice: they could sell the stock or find yield elsewhere. But GE’s corporate bondholders didn’t suffer any interruption in their regular interest payments, though the value of their GE bonds did fall sharply.
Some companies pay dividends on their stock, but that’s often the first distribution to investors or shareholders that gets chopped when hard times come. And that’s one reason why investors looking for income might want to consider corporate bonds, even though—like any investment—they come with risks of their own. In general, corporate bonds are considered a bit less risky than company shares, which can be affected by dividend cuts as well as stock market turbulence.
“If you’re an equity investor, a corporate bond gives you an opportunity to own a different security or instrument relative to a company you may already be aware of,” said Craig Laffman, director of fixed income trading and syndicate for TD Ameritrade. “So if you own a certain stock, that company may also offer bonds. Investors may have affinity for that name. And depending on where you are in the market cycle, a corporate bond should yield more than a stock dividend.”
“The great thing about a corporate bond is that it can offer a steady income stream and can be a stable investment, provided there’s no credit event,” Laffman continued. “Investors can buy the bond, collect the interest payments, and receive their initial investment back when the bond matures.”
Sounds good. But it doesn’t necessarily mean there’s no risk. Later, we’ll explore how “credit events” and interest rate changes might hurt corporate bond investors.
Before diving deeper into corporate bonds, their potential benefits and risks, and why investors might want to consider them, let’s take a quick look at the basics. What is a corporate bond and how does it work? Remember, corporate bonds are just one type of bond offering. There are also U.S. Treasuries and tax-free municipal bonds.
What Is a Corporate Bond?
Corporations often choose debt to finance acquisitions, upgrade plants or technology, and for other purposes. To accomplish this, they may issue bonds. Bonds are typically made up of three components:
- Principal. This is the face value of the bond—the amount an investor initially pays to purchase it. It’s often set at $100 or $1,000 per bond. The principal is also sometimes referred to as “par.”Maturity. This is the date on which the money loaned—the principal—needs to be paid back.Interest rate. This is the annual amount, expressed as a percentage, that the bond issuer must pay the purchaser over the life of the bond. This is also known as the “coupon.”
Here’s a sample scenario to illustrate how a bond investment might work.
Investments in fixed-income products are subject to market risk, interest rate risk, credit risk, inflation risk, and special tax liabilities. May be worth less than the original cost upon redemption. For illustrative purposes only.
In this example, investor Anne has used the bond purchase to preserve capital—the initial $1,000 investment—while creating annual cash flow—the $50 yearly payments.
How Interest Rates Affect Bonds
But what if our hypothetical investor wanted to sell her bond before the maturity date? In that case, things can get a bit more complicated.
The interest rate of a bond at the time of issuance is affected by two factors: current interest rates and the risk of issuer default. Generally, the interest rate is fixed for the life of the bond. Setting aside default risk for the moment, suppose investor Anne bought a 10-year bond in a low-interest rate climate, but when she wanted to sell it five years later, interest rates had risen significantly.
In this case, other investors could purchase newly issued bonds with higher rates than the one Anne is selling, and thus earn a larger return on their principal. Because of this, Anne’s bond would trade at a discount, also known as “trading below par.” This discount allows the buyer of Anne’s bond to make a similar return on capital as if it were a newly issued bond with a higher interest rate. And remember: regardless of where the bond is bought or sold, at maturity, the bond owner will receive the par value. This is the case if the issuer doesn’t default, of course. The risk of getting nothing back in the case of a default is one that we’ll address below.
On the other hand, when interest rates fall, bond prices tend to rise. So the bond you bought at a higher interest rate might become more valuable in a lower rate environment when companies are issuing new debt with lower yields.
Risks Associated with Corporate Bonds
As we mentioned, risk also plays a part in setting the coupon rate of a bond. Government bonds tend to be less risky than corporate bonds, and thus they usually have a lower interest rate. But there can be different rates even among corporate bonds. This is because of something known as default, or credit risk.
Default risk is the estimated risk that an issuer might go out of business and not be able to pay back the principal—and any remaining interest—on its bonds. The riskier the issuer, the higher the interest rate offered.
Corporations do sometimes default on bonds, which makes corporate bonds a riskier purchase than government ones. Investors should research the risk before buying. For instance, if a company has recently cut its dividend, that could be a warning sign that things might get worse.
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“As a holder of common stock, if there is a financial event, the first thing a company tends to do is to cut or remove the dividend,” Laffman explained. “Then, depending on how the financial situation starts to unfold, you’ll see the issuer begin the process of suspending interest payments up the capital structure.” Eventually, if things get bad enough, a company might declare bankruptcy and bondholders might not get back their investments.
Much of the risk in buying bonds can be mitigated by buying only those that are highly rated. Various agencies like Moody’s and Standard & Poor’s issue, track, and update bond ratings on a regular basis, but they each have their own grading criteria, so investors need to educate themselves first.
Bonds can be an integral part of an investment portfolio. For those who aren’t sure where to start, TD Ameritrade clients can use the TD Ameritrade Bond Wizard to walk through the process of discovering bonds that meet unique criteria.
Not All Corporate Bonds Are Created Equal
Corporate bonds fall into more than one category. Some are considered investment grade, while others are considered high yield, or “junk” bonds. The difference is the credit quality of the bond issuers. A high-yield bond issuer typically has a weaker track record or financials compared to one that can issue a bond at investment grade. Investment grade is BBB or above, as rated by Standard & Poor’s.
However, even among investment-grade bonds, there are ways a savvy investor can measure the possible risk.
“In the investment-grade space, you can start to see where the issuer might begin the process of having a credit-specific event,” Laffman explained. “Everything is on a spread basis. If we see the BBB-rated industry average is 160 basis points above the corresponding Treasury, but a specific corporate bond is paying 220 basis points above the Treasury, it could indicate the market is factoring in some increased risk that maybe the ratings industry hasn’t noticed yet. Markets tend to move much faster than ratings agencies.”
Laffman added, “For an investment-grade bond, credit events do occur, but they’re more the exception than the norm.”
Who Invests in Corporate Bonds?
Corporate bonds can arguably be useful in many portfolios across investor types. For instance, older investors closer to retirement who don’t necessarily need outright growth often seek stability and income with corporate bonds, according to Laffman.
Younger investors with heavy exposure to stocks sometimes diversify with corporate bonds for their perceived stability.
Purchasing a corporate bond ETF or corporate bond fund may help an investor spread the credit risk across a number of different bond issuers, meaning that if any one issuer defaults, most of the investment isn’t usually affected. That might be one reason some financial experts suggest that purchasing individual corporate bonds might not be for every investor. But fund investing does come with its own set of risks, fees, and tax implications.
So if you’re considering investing in bonds, whether through individual offerings or through a bond fund, be sure to do your homework. And if you need help, consider reaching out to a TD Ameritrade Fixed Income Specialist at 877-883-2835.
Investing Basics: Bonds