Corporate Bonds, Risks and Benefits
Life is risky. Every day investors are faced with complex choices in the face of deep uncertainty. What to do? Look at history and realize that the odds favor the educated. One opportunity for learning comes in the form of corporate bond offers.
Corporations raise funds in a variety of ways - income from sales or services, straight bank loans and stock floats. One of most common but least understood methods by the average investor, though, is issuing bonds.
Essentially a loan by an investor to the company, like all loans they have a due date (maturity) and an associated interest rate (coupon). Maturities are typically less than ten years and interest rates vary from nothing (zero coupons) to higher than average market (high yield).
But, alas, nothing is without risk and where corporate bonds are concerned it comes in several forms.
RISKS
Credit Risk
Some companies, like some individual borrowers, default on their bonds. They may even continue in business afterwards and investors are left with the choice of whether to sue or seek other means of compensation.
Fortunately, Moody’s and Standard & Poor’s (as well as other firms) rate credit risk on bonds according to often highly reliable scales ranging from AAA (very low risk, but usually low yield) to D (don’t even think about it), with BB considered junk range (risky, but high yield).
Interest Risk
Every bond is issued with some interest rate and some even change over time. A relatively recent innovation, they’re called ‘floaters’ whose coupon rates vary with short-term or other index measures. Sometimes those rates vary continuously with market changes, some change in pre-set steps over the life of the bond.
Since general interest rates can change, a bond purchased today offering 5% is worth less if interest rates in general rise to 8% a year later. (An unusually high increase, but not unknown.) The price of that bond will decrease for those wanting to sell prior to maturity, and yield less over time than a newly purchased bond for those thinking of holding until maturity.
Risk and difficult choices are inseparable.
Maturity Risk
Some corporate bonds are issued with a proviso that they are ‘callable’. I.e. they can be redeemed (usually at face value) prior to maturity. Companies do this when interest rates fall, and they wish not to continue making high interest payments to bondholders. They can either pay back with available cash, or with new bonds or bank loans, a form of corporate ‘re-financing’ similar to that done by homeowners.
That callable feature represents the risk to an investor that, though initially receiving high interest payments, they may not be able to enjoy that same rate for the life of the bond. As a consequence, those bonds are often discounted in some form to compensate.
BENEFITS
High Yield
High yield bonds are just what the name suggests - they pay a higher rate of return in exchange for perceived higher risk. Not all fall into the category of ‘junk’ and savvy investors have often profited handsomely from them.
Convertible Bonds
Convertibles offer investors the right to acquire a company’s common stock under specified conditions rather than by direct purchase in the market. Newly issued convertibles usually have a lower maturity (of 5 to 10 years) and offer a lower coupon rate than that of nonconvertible bonds of comparable quality.
Convertibles offer the potential for profiting from a company’s stock price appreciation, combined with the relative safety of a bond. If the price of the underlying stock declines, the bond’s price normally falls only to a point where it yields a decent return as a straight bond.
As with any investment, always do your homework. But don’t be turned away by the relatively higher complexity of bond investing. Both the risks and returns of bonds are easier to judge with confidence than many other investments, once an investor climbs part way up that knowledge curve.