The idea behind corporate bonds is very simple: companies issue bonds to fund their operations.
There are 2 major ways for a corporation to raise cash: sell its shares or issue bonds. Popular among investors worldwide, corporate bonds usually have higher interest rates and are backed by the company’s payment ability.
Investing in corporate bonds
When investors buy a bond, they lend money to the corporation that issues this bond. The notion of a bond presupposes a promise, or obligation, to repay the bond’s face value (the loaned amount) with a specified interest rate at a predetermined period of time.
Corporate bonds are issued by companies and can be either private or publicly traded. Every bond is classified according to its risk factor. Special bond rating services – Standard & Poor’s, Moody’s and Fitch – dominate the industry and estimate the risk of each bond issue. After the estimation, the bond receives its rating, which signifies its risk factor.
For example, corporate bonds ranked three-A (AAA) are considered the most reliable and safe, while bonds rated three-B (BBB) and further are the most risky. While calculating the bond’s risk factor, experts estimate the company’s growth potential, current debt and overall financial stability.
Corporate bonds investments in a well-diversified portfolio, including long-term, mid-term and short-term maturity bonds, can save you money for retirement, education or just help to create an additional budget for a rainy day.
Corporate bonds trading: explore the options
Some corporate bonds are traded on the OTC (over-the-counter) market and provide good liquidity. You can also trade corporate bonds on the primary market through brokerage firms or banks, who often take a commission for facilitating transactions.
If you choose to trade individual corporate bonds through an online broker, you should first research the background of the bond-issuing company and their underlying fundamentals – just to make sure you don’t buy a risky bond at the edge of a default.
To keep your investments safe, you should also ensure your portfolio is well-diversified among bonds of different sectors (financials, technology) and different maturities.
You can also invest in corporate bonds through mutual funds or ETFs (exchange-traded funds). Having their own set of risks, mutual funds offer a benefit of ready-made diversification and professional management.
How to choose the best corporate bonds to invest in
Not all corporate bonds are equal. In order to pick up those which best suit your investment goals, ask yourself 3 major questions.
Can the issuing corporation pay its bonds?
Beyond the official bond ratings, the quickest way to find out whether the company’s bond is safe is to look at how much interest it pays relative to its income. To begin with, check out the company’s income statement, which is available for publicly traded companies. There you should pay special attention to the annual operating income and interest expense.
If you divide the company’s operating income by its interest expense, you may get the following results:
1) 4 or higher: the company is strong and has no problems meeting its obligations.
2) 2.5 to 4: Everything seems ok, but at the lower end of the range and therefore may take further consideration.
3) 1 to 2.5: The company may find it difficult to pay its debt if business gets worse.
4) Below 1: The company would likely have problems paying its debt.
Is it the right time to invest in bonds?
Bond prices tend to move cyclically. When the economy boosts, interest rates rise, depressing bond prices. And vice versa, when the economy drags down, interest rates falls, lifting bond prices up.
To diversify the interest-rate risks, many bond investors “ladder” their bond exposure. They buy numerous different bonds that mature across a period of years. When the bond matures, the principal is reinvested and the ladder grows.
Which bonds are right for me?
Investors usually choose corporate bonds by looking at their yield advantage or yield spread. Financially strong, highly-rated companies with billions of income on their balance sheet – think Google or Microsoft – can usually offer bonds with lower yields. The investors may be sure that these companies won’t default.
At the same time, lower-rated companies with unreliable revenue streams or higher debt should offer higher yields to attract investors to buy their bonds
3 major reasons to invest in corporate bonds
Why might investors resort to corporate bonds?
A buffer against market volatility
Corporate bonds may be a less risky way to gain exposure to corporates than stocks. There is also the possibility that they might pay investors a more stable dividend.
Corporate bonds are expected to provide investors with a higher yield than term deposits and government bonds.
Benefits of diversification
Being exposed to a large number of securities, a diversified portfolio minimises the risk of a default of one single company and its bonds.
Traditionally considered less risky than shares, bonds provide a good chance to invest in companies with strong corporate fundamentals. The corporate bonds market offers numerous options to find your own risk and return combination that suits your investment goals. A core component of an income-oriented and well-diversified portfolio, corporate bonds should definitely attract your attention as a trader.