Corporate Bond Funds: Worthy Investment Or Risky Business?

Corporate bonds are a type of investment where you lend money to a company in exchange for regular interest payments. They are considered a lower-risk option compared to stocks, as they offer a stable income through regular cash payouts and are less volatile. However, they also have limited upside potential and may be riskier than government bonds. When considering investing in corporate bond funds, it is essential to understand the risks and rewards, selection factors such as credit ratings and interest rates, and the different types of corporate bonds available, such as fixed-rate, floating-rate, zero-coupon, and convertible bonds. Additionally, investors should be aware of the fees associated with corporate bond funds, such as expense ratios, and consider their investment objectives, risk tolerance, and diversification within their portfolio.

What are the risks and rewards?

Corporate bonds can be a good investment option for those seeking a lower-risk, lower-return way to bet on a company's success. They offer regular cash payouts, and their price tends to fluctuate less than stocks.

Rewards

• Regular cash payments: Bonds make regular cash payments, which is not always the case with stocks. This provides a high level of certainty regarding income.
• Less volatile price: Bonds are generally much less volatile than stocks and are less susceptible to factors such as interest rate changes.
• Lower risk than stocks: Bonds are considered less risky than stocks and are among the best low-risk investments. For a successful bond investment, the company simply needs to survive and pay its debt, whereas a successful stock investment requires the company to thrive.
• Higher yields than government bonds: Corporate bonds tend to offer higher yields than equivalently rated government bonds.
• Access to a secondary market: Investors can sell bonds in the bond market, providing liquidity for their holdings, which is not possible with bank CDs.

Risks

• Fixed payments: A bond's interest rate is set when issued, and investors will only receive this predetermined amount. This is in contrast to dividend stocks, which can raise their payouts over time.
• Riskier than government debt: Corporate bonds yield more than government bonds because they are riskier. Governments can raise taxes or issue currency to repay debt if needed.
• Low chance of capital appreciation: Bonds have a low chance of significant capital appreciation. The expected return on a bond is its yield to maturity, which is generally lower than the potential returns of stocks.
• Price fluctuations: Bond prices can fluctuate, unlike CDs. Investors may not get their full investment back if they need to sell a bond before maturity.
• No insurance: Bonds are not insured, unlike FDIC-backed CDs. Investors can lose principal on their bonds, and the company could default, resulting in a total loss.
• Analytical work required: Investing in individual bonds requires analysis of the company's ability to repay the bond, which can be time-consuming.
• Exposure to rising interest rates: Bond prices fall when interest rates rise, and investors often don't benefit from a rising payout stream to compensate.

Overall, while corporate bonds offer a relatively stable and predictable investment option, they are not without risks. It is important for investors to carefully consider their financial goals, risk tolerance, and conduct thorough research before making any investment decisions.

How do they compare to stocks?

Stocks and corporate bonds differ in several ways, and each has its own advantages and disadvantages. Here is a detailed comparison between the two:

Risk and Return

Stocks represent direct ownership in a business, while corporate bonds are a loan with a predetermined rate of return. Investing in stocks can offer higher returns over the long term, but it comes with higher risk. Stocks are more volatile and can substantially fluctuate based on future earnings projections and market performance. On the other hand, corporate bonds are generally less risky and tend to hold their value. They offer a regular cash payout and lower volatility, making them a more stable investment option. However, the stability of corporate bonds comes at the expense of lower long-term returns compared to stocks.

Income and Appreciation

Bonds offer a regular cash payout, providing a high certainty of income. In contrast, stocks do not always offer regular cash payments, as dividend payouts are not guaranteed and can vary. Stocks have a higher chance of capital appreciation over time, whereas bonds have a limited upside potential due to their fixed payments. Stocks can continue to rise for decades, earning much more than what a bond could provide.

Market Volatility

Corporate bonds are often considered a safer investment option during market volatility. They tend to be less volatile than stocks and can preserve capital during market downturns. Bonds are less affected by market conditions and are influenced by factors such as interest rates and the company's credit rating. Stocks, on the other hand, are more susceptible to market fluctuations and can experience significant losses during market volatility.

Liquidity and Accessibility

Stocks are generally more liquid than corporate bonds. They can be easily bought and sold on stock exchanges, providing higher liquidity for investors. In contrast, corporate bonds may be more challenging to buy and sell, especially for individual bonds with higher minimum investment requirements. However, bond funds, such as bond ETFs, offer better liquidity and allow investors to buy a diversified group of bonds with lower minimum investments.

Suitability

The suitability of stocks or corporate bonds depends on an investor's goals, timeline, and risk tolerance. Stocks are suitable for investors with a longer time horizon who are willing to take on more risk to achieve higher returns. Corporate bonds, on the other hand, are more suitable for investors seeking a more stable and predictable investment with lower risk. They are ideal for those nearing retirement or needing their investments to produce income.

What types of corporate bond are there?

Corporate bonds are classified based on credit quality, interest payments, and maturity periods. Here are the main types:

• Maturity-based classification: These bonds are segmented into short-term (maturing in fewer than three years), medium-term (maturing in four to ten years), and long-term (maturing in more than ten years).
• Credit rating-based classification: Based on the risk assessed by credit rating agencies, these bonds are classified as investment-grade (low risk) or non-investment grade (high risk, or "junk bonds").
• Interest payment-based classification: These bonds are classified into fixed-rate (with a fixed interest rate throughout the term), floating-rate (variable interest rates that change based on market fluctuations), and zero-coupon (no interest payments; the bondholder receives a one-time repayment when the bond matures).

Other types of corporate bonds include:

• Convertible bonds: These give companies the flexibility to pay investors with common stock instead of cash when a bond matures.
• Premium bonds: Bonds that go above their issue price.
• Discount bonds: Bonds that fall below their issue price.

How do I buy them?

There are several ways to buy corporate bonds. Here are the most common methods:

Primary Market

You can buy corporate bonds directly from the issuer on the primary market at face value. However, new-issue bonds are often sold in blocks of $1,000 per bond, which can be expensive for building a diversified portfolio.

Secondary Market (Over-the-Counter Market)

The secondary market, also known as the over-the-counter (OTC) market, is where you can buy and sell already-issued bonds. These bonds are traded by investors who want to sell before maturity. The price on the secondary market may be higher or lower than the face value, depending on interest rates and the financial health of the issuing company. Bonds on this market may offer good liquidity, making it easier to sell them for cash. You will need to use a broker or dealer to facilitate purchases or sales on this market.

Online Broker

You can purchase corporate bonds on the secondary market through an online brokerage account. You may find bonds selling at a discount due to interest rate movements or other economic factors.

Exchange-Traded Funds (ETFs)

ETFs allow you to invest in a broad group of corporate bonds from multiple companies. They are already diversified and tend to be much cheaper than purchasing individual bonds. The minimum investment is usually the price of a single share of a bond ETF, making them more accessible for smaller amounts of money. However, keep in mind that there are fees associated with bond funds, so be sure to understand the expense ratio before investing.

What are the tax implications?

The tax implications for investors in fixed-income securities like corporate bonds can vary depending on the type of security purchased. In general, investors in corporate bonds will owe taxes on interest income and capital gains.

Interest income generated by corporate bonds is fully taxable at all levels. Investors who own 100 corporate bonds at $1,000 par value, with each paying 7% annually, can expect to receive $7,000 of taxable interest income each year.

When investing through a tax-deferred account (such as an individual retirement account (IRA) or 401(k)), buying corporate bonds with high yields may give you a return advantage over municipal bonds in a taxable account, despite the tax benefits that municipal bonds offer.

Capital gains are profits earned by an investor at the time of maturity. Capital gains are different from interest income paid by bonds. Regardless of the type of bond, any debt issue purchased and sold in the secondary market will post a capital gain (or loss). This includes government and municipal issues, as well as corporate debt. Gains and losses on bond transactions are taxed at the appropriate capital gains tax rate.

There are two types of capital gains: long-term capital gains and short-term capital gains. In the case of listed bonds, if the holding period is more than 12 months, the realised returns are considered long-term capital gains. When the holding period is below 12 months, individuals earn short-term capital gains upon the sale of these bonds. Short-term capital gains are taxed at the applicable slab rate, while long-term capital gains are taxed at a rate of 10% without indexation.

Additionally, the amortizable bond premium, which refers to the price paid for a bond above its face value, can be tax-deductible and amortised over the lifespan of the bond. Amortising the premium can be advantageous since the tax deduction can offset any interest income the bond generates, thus reducing an investor's taxable income.

It's important to consult with a tax advisor or certified public accountant (CPA) to understand the specific tax implications of investing in corporate bond funds and to determine how they fit into your overall investment strategy.

Frequently asked questions