Companies issue debt in the form of bonds to finance their business operations. These are known as corporate bonds.
Equity is where a company raises capital by selling a part of its ownership through a stock issuance. In case of corporate bonds, the company raises cash by borrowing at an interest rate for a specified time period.
For instance, Company X might issue a 15-year bond with a $30 million issue size to fund its new manufacturing operation, develop a new technology, or simply fulfill its ongoing working capital requirements.
Investors who trust the company’s business model and performance track record may purchase those corporate bonds with an aim to earn a higher yield compared to traditional safe investments such as government securities.
Nearly one-fifth of the overall bond market in the United States is historically made up of corporate bonds. In an era where the government bond yields have fallen steadily, a number of actively managed investment funds have chosen to make significant allocations to corporate bonds.
How to invest in corporate bonds?
You can usually invest in corporate bonds in two ways.
Individual investing: The first option is to buy a particular company’s bonds through an agent or broker. This type of independent investing requires that you should have a good understanding of the issuing corporation’s underlying business strengths and financial capabilities in order to carefully balance your risk and returns.
It is important to have diversified bond portfolio that includes bonds of reputable companies in different sectors such as banking, technology, or consumer goods.
ETFs or mutual funds: If you are new to the world of corporate bond investing, you may consider the second option of investing through an exchange traded fund (ETF) or a mutual fund.
While the funds do have a risk in the sense that they are heavily dependent on the skills of the fund manager, the advantage is they will usually have well-diversified investments in various corporate bonds and will be backed by professional management.
To compare the performance of different mutual funds and ETFs, you can use online tools provided by websites such as XTF.com or Morningstar.com.
When you invest through funds you may choose funds that focus on emerging markets or developed international markets for higher bond yields.
How to determine bond valuation?
Investors typically consider U.S. Treasurys as the benchmark to evaluate their yield advantage (the “yield spread”) while considering corporate bonds. U.S. Treasurys offer the lowest yield because they are perceived to be virtually free of risk of default.
Companies that are globally competitive with very strong balance sheets, such as Amazon or Microsoft, are able to sell their bonds at relatively low yields because their default risk is minimal.
On the other hand, companies with lower debt ratings because of uncertain future revenues or high amounts of existing debt may have to offer their bonds at higher yields to raise capital.
You have to consider your risk appetite and your investment goals to make a choice on yield spread. You may keep adjusting your risk-reward ratio while also considering the macro-economic conditions within the country as well as what is occurring globally.
Short term vs. long term bonds: While making your investment decision you should also consider whether the corporate bonds have been issued for a short- or long-term.
You are likely to achieve lower yields on short term bonds because of the basic investing principle that there is lesser visibility about a company’s financial future over a 20-year period rather than a four-year period. Therefore, the price volatility in long-term bonds is often much higher.
If you choose to invest in corporate bonds through a fund they will usually combine bonds of different yields, credit ratings, and maturities in order to optimize returns while minimizing the risk.
Risk profile of corporate bonds
Compared to equity investing, corporate bond investing is considered to be safer and less volatile. Bonds have historically shown a lower incidence of default. The average default rate of top investment grade bonds (which have the highest AAA credit rating) since the last four decades has been zero.
Therefore, you can diversify the risk in your investment portfolio by allocating a percentage of your funds to the highest-rated bonds.
The performance of mutual funds and ETFs focused on corporate bonds may be affected due to two external factors:
Prevailing interest rate environment: As we discussed, the valuation of corporate bonds is determined according to their yield spread compared to U.S. Treasurys.
Any change in the government bond yields will have a direct correlation with the corporate bond yields. It’s paramount to understand that bond yields and prices will always move in opposing directions.
Macro-economic risk perception: The performance of corporate bond yield may sometimes have nothing to do with the issuing company’s business or financial performance.
If investors perceive a higher degree of risk in the global economic environment or foresee an economic slowdown or recession they may have a reduced appetite for bond investing.
In a pessimistic economic environment, investors tend to prefer for long-term bonds over short-term bonds, thus driving the yields of long-term bonds down.
When the yield of a 10-year bond gets lower than that of a two-year bond, it indicates an “inverted yield curve,” which is widely considered as a reliable indicator of an oncoming recession.
When the global economy goes through disruptive events, investors may prefer safer investment options such as government bonds while staying away from corporate bond investing.
Bond bottom line
Over longer time periods, economic optimism has historically prevailed over negative market sentiment.
For a reasonable risk, corporate bonds continue to deliver attractive and stable returns to investors. However, mutual funds and ETFs that focus on corporate bonds may be a better choice for new investors over individual bond investing.
The corporate bond market offers a wide range of options for all types of investors in terms of a risk-reward ratio that matches appropriately with their needs. Corporate bond investing should be a significant component of a concrete, income-driven investment portfolio.