Within a taxable brokerage account, municipal bonds are usually considered a good choice because of their tax benefits. The coupon payments are not taxable at the federal level, and if you invest in municipal bonds issued in your home state, the coupon payments aren’t taxable at the state or local level either.
However, in retirement accounts, the tax benefits of municipal bonds are wasted; retirement accounts already offer tax-deferred growth. Instead, corporate bonds are usually the preferred choice in retirement accounts. Here are some of the benefits of corporate bonds, and strategies for building a corporate bond portfolio:
What is a Corporate Bond?
A corporate bond is a debt security that a publicly traded company issues to investors to raise money. Corporate bonds are usually issued in $1,000 increments. When an investor buys a $1,000 corporate bond, they are loaning the company $1,000. In exchange, the company pays the investor interest at regular intervals (for example, every six months). These interest payments are called coupon payments. When the bond matures, the investor gets their $1,000 principal back.
Each major category of corporate bonds includes several subtypes.
Investment Grade Corporate Bond
An investment grade corporate bond has a high rating from Moody’s, Standard & Poor’s, or Fitch (the three major bond credit rating agencies). This high rating means the bond issuer is not likely to default. As an investor, you can expect to receive all your coupon payments until the bond matures, and you can expect to receive 100% of your principal back, too. Because these bonds are relatively safe investments, their interest rates are relatively low.
High-Yield Corporate Bond
A high-yield corporate bond, also called a non-investment-grade bond, is one that pays more interest because it has a lower credit rating (below investment grade). These bonds pose a greater risk to investors, who may not receive all their coupon payments, and may lose some or all of their principal. The corporations that have issued these bonds are generally experiencing some sort of financial trouble.
International Corporate Bond
An international corporate bond is one issued by a company that is not based in the United States. The yield and risk of these bonds can vary significantly. They depend not only on the issuer’s creditworthiness, but also on the stability of the country’s currency and its relationship to the US dollar. International bonds are issued in and make coupon payments in their domestic currency, so foreign investors face currency risk, along with credit risk, when they purchase international corporate bonds.
Emerging Market Corporate Bonds
Emerging market corporate bonds are international bonds issued in developing countries like China, Mexico, India, and the Philippines. Emerging market economies tend to grow faster than developed economies, but they are also less stable and pose more risk. When investors buy emerging market corporate bonds, they face credit risk, currency risk, and country risk, plus the possibility of destabilizing economic and political events that will impact the bond’s value.
Within these major categories, you can also choose bonds with varying maturity lengths (also called terms or durations), and different credit ratings. You could buy an investment grade corporate bond from Apple with a maturity of two years if you wanted something low-risk. If you wanted to take on a lot of risk, you could buy a non-investment-grade emerging market bond with a 10-year maturity.
Why Add Corporate Bonds to Your Retirement Portfolio?
Normally, an investor adds bonds to their portfolio as part of an asset allocation strategy to reduce the overall risk level of their portfolio. (For example, the goal might be to create a balanced portfolio with 60% stocks and 40% bonds.) Bonds are used as an asset allocation to lower your portfolio's risk because they are traditionally less volatile, and not correlated to the stock market. In other words, they don’t typically move in the same direction as one another. However, factors such as bond type and what stage of an economic cycle we are in affect how closely stocks and bonds are correlated. For example, high yield corporate bonds tend to be more closely correlated to stocks than investment grade corporate bonds.
After many years of holding the rate near zero, the Federal Reserve began increasing its target interest rate, or the amount that it charges banks to lend to each other, in December 2015. Currently, the fed funds rate is targeted at 1.75% to 2.00%. When the Federal Reserve met in June 2018, the government agency planned to continue increasing rates to try to keep its inflation and employment goals for the economy on track.
A rising rate environment is generally not good for mid- to long-term corporate bonds. As interest rates rise, bond prices tend to fall, because they generally have an inverse relationship to one another. That being said, high-quality corporate bonds can be a better bet than government bonds in a rising interest rate environment because corporate bonds are less sensitive to rising interest rates. In addition, floating-rate corporate bonds, typically called Floating Rate Notes (FRNs), carry variable interest rates and may do better in a rising rate environment. However, it's important to remember that FRNs are often issued by companies rated below investment grade, which increases their risk level.
How Should You Buy Corporate Bonds?
When adding corporate bonds to your retirement portfolio, you have two main choices: create your own portfolio of individual corporate bonds that includes U.S. corporate bonds, high-yield bonds, international corporate bonds, and emerging market corporate bonds, or choose a low-cost corporate bond fund or exchange-traded fund (ETF) that invests in these same assets.
Build Your Own Bond Portfolio
If you create your own portfolio, you will have the advantage of being able to buy and sell based on relative value, receiving a steady cash flow from regular coupon payments and knowing when your principal will be returned. The disadvantages of creating your own bond portfolio include the time and research involved, and having less diversification than a bond fund or ETF (which could mean your bearing the full brunt of one of your bond holdings defaulting on interest or principal payments).
If you decide to create your own portfolio, constructing a bond ladder is a smart choice. By purchasing bonds with staggered maturity dates – 10 bonds where the first bond matures after one year, the second matures after two years, etc. – you’ll have a regular infusion of principal to reinvest. In a rising-rate environment, you’ll be reinvesting in bonds that pay more.
The advantages of choosing a bond mutual fund or ETF include having your interest payments automatically reinvested if desired, and you are allowed to receive broad diversification for a small initial investment. You may also save some research and management time. But while you don’t have to research individual bonds, you still have to research the ETFs or funds you’re considering.
Choose a Bond Mutual Fund or ETF
The disadvantages of choosing a bond mutual fund or ETF include: the shares you purchase in a bond mutual fund or in ETFs don’t have a “maturity date” which means unlike owning individual bonds that return your principal payment at maturity, there is no such fixed redemption price or maturity date for your shares. The value of your shares will continuously fluctuate based on the value of the underlying portfolio of bonds. Bond funds or ETFs also carry ongoing management fees which can reduce your overall yield.
Corporate Bonds Provide Benefits in a Retirement Portfolio
Corporate bonds provide many benefits in a retirement portfolio, from offering low interest rates in some cases, to reducing the overall risk level of a portfolio. Before deciding to build your own corporate bond portfolio, or choosing a bond mutual fund or ETF, it's important to understand all of your options for corporate bonds, and the advantages and disadvantages of building your own portfolio or choosing a fund that invests in these same assets.