First and foremost, if you want to learn how to buy corporate bonds, you should know what are corporate bonds.
What are corporate bonds?
They are bonds that are issued by a company as a way of raising additional money for business, basically they are a certificate of debt that are issued by major companies around the world.
To put it lightly, when you are buying a corporate bond, you are a borrower and you are lending money to a company in exchange for an IOU. Typically, the IOU has a term and at maturity date which can range from several months to several years, the sum invested is returned in full.
On the other hand, the company you are lending your money to can go to bust and in that case, the company has to go through liquidation in which you should get all of your money back.
Also, the bond has a coupon which is also called an interest. this mean as long as you hold that said bond, you are paid that coupon annually or semi-annually and if you keep it until the maturity date, you will get your capital back.
Moreover, look at the company that is issuing the bond. Sometimes, more risky firms have to offer higher interest rates in order to tempt potential investors.
Four main groups of corporate bonds
- Financial services
- Industrial services
Corporate bonds can also be classified by the type of asset which serves as a collateral to secure the loan. This collateral can come in the form of mortgages, machinery, various equipment, etc.
Corporate bonds that come without any specific collateral are also known as debentures.
Furthermore, corporate bonds can be divided by seniority. That means if the company goes bankrupt, corporate bonds that are issued as “senior bonds” are higher in the pecking order. And if you hold a “junior bond” that you will be getting paid back later.
Credit ratings and bonds
When it comes to the bond, an investor needs any help he or she can get. This help comes in the form of credit ratings as that particular rating quantifies some of the risks that are involved in the particular bond. Unfortunately, evaluating credit risk is far more complex for corporate bonds because you, as the investor, have to check issuer’s credit-worthiness and several other factors. For example, the trends within the issuer’s sector, the quality of the management team, overall economic environment (laws, technology, jurisdiction, etc.).
But, credit ratings provide some basic insight into the risks you will have if decide to invest into a particular bond. You should always look at the bigger picture and if you feel any uncertainty about the issuer’s business or even economic environment, do not take the credit rating for granted. It is not worth the risk.
Of course, the worst thing that can happen is the issuer defaulting and that can impact your bond in two different ways.
- You coupon payment could be temporary suspended or even worse, suspended for an unlimited amount of time.
- Second, which is far worse, the issuer cannot return face value at the maturity date.
Sure, you as the bond holder can pursue this legally and collect any repayment from the issuer, but doing so is not easy and can extend for some time. Moreover, even if you are able to collect the full payment, you will most likely receive only pennies on the dollar. As always, there are risks involved.
On the other hand, we have corporate bonds that are rated as investment-grade or even higher (usually abbreviated as Baa3 and BBB-). These type of corporate bonds have very low chance of defaulting but the yield is not that high. Furthermore, we have “junk bonds”. Their rate of default is much higher and so is the yield. Usually, you should avoid junk bonds if you don’t like playing with fire since considerable amount of risk is involved.
Don’t forget about fine print. If you would compare any corporate bond to a muni, you would see that a lot of clauses are involved like call and put features, floating coupons, equity components, etc. Before purchasing a corporate bond, you should always review them as carefully as possible to understand every single aspect of that particular corporate bond. If the need arises, you should consult your legal counsel.
Investing in corporate bonds
First of all, you should know that corporate bonds are fully taxable at the federal, state and local levels. On the other hand, you can invest into munis or Treasuries which are not taxable.
When looking at other risk factors, be sure to do after tax-basis when comparing different bond yields.
Why should you invest in corporate bonds?
- First, look at your portfolio and bonds should be a part of your asset allocation plan.
- Higher interest rate and tax break sine corporate bonds are taxable.
- Look for the liquid market when purchasing your bond. In most cases, large companies are more liquid than munis.
- You believe in the company that is issuing the bond, you buy its products regularly or simply, you want to support it.
- Perhaps you are way too paranoid when it comes to the stock market.
- You simply expect low-interest rates in the future.
How to buy corporate bonds?
Well, it is pretty easy to be honest. Usually, investors buy corporate bonds through different funds. Funds invest in a number of different companies and help to spread the risk accordingly. Unfortunately, you will have to pay fund manager through different fees which can climb up to 2 or 3%, sometimes even higher.
What a fund manager does, is he tries to take advantage of various swings in the market. He or she tries to buy traded bonds below par or sell them above the par.
If the fund manager knows what he or she doing, he can give a fund a super-charge along with its income return. More so, a good bond fund could potentially rise in the value thanks to some solid trading and deliver a nifty income return and capital growth. Don’t forget that holding a bond also spreads risk among many other companies.
Imagine this, if you keep buying a bond for just one individual company, you are putting all of your “eggs” in one basket and not spreading any risk, but if you buy a bond from different companies, you would allocate the possible risk.
Concluding on corporate bonds
In general, corporate bonds are mostly safe, but they are an investment just like any other and not a savings product. If you are an inexperienced investor or do not understand the market, you should definitely seek a professional, independent advice from an advisor.