Investors considering fixed-income securities might want to research corporate bonds, which some have described as the last safe investment. As the yields of many fixed-income securities declined after the financial crisis, the interest rates paid by corporate bonds made them more appealing. Corporate bonds have their own unique advantages and disadvantages.
- Corporate bonds are made up of the debt securities that companies issue to bondholders in order to raise capital.
- Corporate bonds are often seen as the "yin" to stocks' "yang", and a key component of any diversified portfolio.
- Corporate bonds are diverse, liquid, and lower volatility than stocks, but also provide generally lower returns over time and carry credit and interest rate risk.
Advantages of Corporate Bonds
One major draw of corporate bonds is their strong returns, compared to other bond, such as government bonds.
Many corporate bonds trade in the secondary market, which permits investors to buy and sell these securities after they have been issued. By doing so, investors can potentially benefit from selling bonds that have risen in price or buying bonds after a price decline.
Some corporate bonds are thinly traded. Market participants looking to sell these securities should also know that numerous variables could affect their transactions, including interest rates, the credit rating of their bonds, and the size of their position.
There are many types of corporate bonds, such as short-term bonds with maturities of five years or less, medium-term bonds that mature in five to 12 years and long-term bonds that mature in more than 12 years.
Beyond maturity considerations, corporate bonds may offer many different coupon structures. Bonds that have a zero-coupon rate do not make any interest payments. Instead, governments, government agencies, and companies issue bonds with zero-coupon rates at a discount to their par value. Bonds with a fixed coupon rate pay the same interest rate until they reach maturity, usually on an annual or semiannual basis.
The interest rates for bonds with floating coupon rates are based on a benchmark, such as the Consumer Price Index (CPI) or the London Interbank Offered Rate (LIBOR), adding a certain number of basis points (bps) to the benchmark. The interest payments change along with the benchmark.
A step coupon rate provides interest payments that change at predetermined times, and usually increase. Most of these securities come with a call provision, meaning that investors receive the initial interest rate until the call date. After reaching the call date, the issuer either calls the bond or hikes the interest rate.
Disadvantages of Corporate Bonds
One major risk of corporate bonds is a credit risk. If the issuer goes out of business, the investor may not receive interest payments or get his or her principal back. This contrasts with bonds that have been issued by a government with a high credit rating, as this entity could theoretically increase taxes to make payments to bondholders.
Another notable risk is event risk. Companies might face unforeseen circumstances that could undermine their ability to generate cash flow. The interest payments – or repayment of principal – associated with a bond depend on an issuer's ability to generate this cash flow. Corporate bonds can provide a reliable stream of income for investors. These debt-based securities became particularly attractive after the financial crisis, as central bank stimulus helped push the yields lower on many fixed-income securities. Interested investors can choose from many kinds of corporate bonds, and these securities frequently enjoy substantial liquidity. However, corporate bonds have their own unique drawbacks.
The Bottom Line
Like anything in life, and especially in finance, corporate bonds have both pros and cons:
Tend to be less risky and less volatile than stocks.
Wide universe of corporate issuers and bonds to choose from.
The corporate bond market is among the most liquid and active in the world.
Lower risk translates to lower return, on average.
Many corporate bonds must be purchased OTC.
Corporate bonds expose to investors to both credit (default) risk as well as interest rate risk.