Bonds issued by the corporations
Corporate bonds generally pay the highest interest rates and are usually available in $1,000 or $5,000 denominations with maturities ranging from under one year up to 30 years. They are the riskiest type of bonds, both in terms of the investor not receiving their coupon payment and in not receiving their principle at maturity.
Corporate bonds are accessed for credit risk based on the financial strength of the issuing company and the company is assigned a credit rating. These credit ratings are used to broadly classify corporate bonds into two distinct groups – investment grade bonds and speculative grade bonds.
The investment grade bonds are usually just referred to as corporate bonds and the speculative bonds are commonly referred to as junk bonds or high-yield bonds.
The interest rate from corporate bonds tends to be around one-percent higher than that for treasury bonds with a similar maturity in a low inflationary environment. The gap can be higher during periods of high inflation. Junk bonds tend to average a few more percentage points but the risk of default becomes much more significant.
With the interest rate gap being quite small between the ultra-safe treasury bonds and the riskier corporate bonds, many new investors to bonds may well wonder whether it’s worth the risk with corporate bonds. After all, if an investor is going to take on risk then why not just invest in stocks and receive around twice the long-term returns available from corporate bonds for the same risk of bankruptcy.
The short answer is that it all depends on the risk appetite and the investing strategy of the investor.
Investor Risk Appetite:
- For the more conservative and risk adverse investor, treasury bonds are more suitable even though they might hold a small portion of corporate bonds.
- For the aggressive or the active investor who is constantly monitoring the financial health of the bond issuing company, then they are likely to sell any corporate bonds deemed too risky. The value of corporate bonds tend to be much more volatile than treasury bonds and active investors make use of this volatility to achieve realized capital gains in the same way as active stock investors achieve realized capital gains.
The Bid-Ask spread tends to be higher with corporate bonds compared to treasury bonds and spread of corporate bonds can range from under 1% to well over 5%. The spread is largely due to the lower liquidity of corporate bonds with the higher spread bonds being more difficult to buy and sell at a fair value.
Corporate bonds tend to perform better than treasury bonds most of the time, especially while the economy is in an expansion phase. However during periods of economic recession, treasury bonds typically outperform corporate bonds.
Junk bonds are also referred to as high-yield bonds and produce higher long-term returns compared to corporate bonds, however the total long-term returns are still several percentage points less than the long-term return from stocks excluding dividends. The same question as with corporate bonds presents itself – why invest in junk bonds? The answer is basically the same as with corporate bonds – conservative investors avoid them outright and active speculative investors seek short-term and medium-term realized capital gains.
Corporate bonds are often callable, which means that the company may cancel the bond contract by recalling the bond before maturity and repaying the bond holder their principle. The specifications for the bond contract states whether the bond is callable.
Investors should be aware that corporate bonds
may be recalled when interest rates drop
The main reason companies recall callable bonds is when interest rates drop and they can simply recall the old bonds and issue new bonds at a lower interest rate. Thus the bondholder only ever gets recalled when it’s the most inconvenient to them. The bondholder loses their high interest paying bonds and they can now only invest in the lower interest paying bonds.
Callable bonds do however tend to have a slightly higher interest rate to entice investors to buy these bonds. Granted, if the investor is not intending on holding a callable until maturity then the early recall is not really an issue and the investor receives a higher interest rate in the meantime.
Another option some corporate bonds have is convertibility which means the bonds can be converted or exchanged for the company’s shares (usually the common stock). This is a feature that some active investors and especially speculative investors make good use off. Convertible bonds were used extensively by Benjamin Graham who was a famous investor renowned for his hedge fund tactics.
The only real downside with convertible bonds is that the interest rates tend to be less than non-callable bonds of similar maturity and credit rating. So the benefit to the investor is largely dependant on whether they have any intentions of converting their bond to common stock (the conversion is usually done when stock prices are favorable).