Corporate Bonds To Invest In – Corporate bonds offer higher returns than other fixed income investments, but at a price in terms of additional risk. Most corporate bonds are debentures, meaning they are not backed by collateral. Investors in such bonds must bear not only interest rate risk but also credit risk, the possibility that the corporate issuer will default on its debt obligations.
Therefore, it is important for corporate bond investors to know how to assess credit risk and its potential returns. And while upward movements in interest rates can reduce the value of your bond investment, a default can all but wipe it out. Defaulting bondholders can get some of their principal back, but it’s often pennies on the dollar.
Corporate Bonds To Invest In
By yield, we mean yield to maturity, which is the total yield resulting from all coupon payments and any “built-in” price appreciation gains. The current yield is the portion generated by coupon payments, which are typically paid twice a year, and contains most of the yield generated by corporate bonds. For example, if you pay $95 for a bond with an annual coupon of $6 ($3 every six months), your current yield is about 6.32% ($6 ÷ $95).
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The built-in price appreciation that contributes to the yield to maturity results from the additional yield that the investor realizes by buying the bond at a discount and then holding it to maturity to receive par value. It is also possible for a corporation to issue a zero coupon bond whose current yield is zero and whose yield to maturity is simply a function of the embedded price appreciation.
Investors whose primary concern is a predictable annual stream of income seek corporate bonds, which produce yields that consistently beat government yields. In addition, the annual coupons on corporate bonds are more predictable and often higher than the dividends received on common stock.
Credit ratings published by agencies such as Moody’s, Standard and Poor’s and Fitch are intended to capture and classify credit risk. However, institutional corporate bond investors often supplement these agency ratings with their own credit analysis. Many tools can be used to analyze and assess credit risk, but two traditional indicators are interest coverage and capitalization rates.
Interest coverage ratios answer the question, “How much cash does the company generate each year to finance the annual interest on its debt?” A common interest coverage ratio is EBIT (earnings before interest and taxes) divided by the annual interest expense. Clearly, since a company needs to generate enough revenue to service its annual debt, this ratio needs to be greater than 1.0 – and the higher the better.
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Capitalization ratios answer the question, “How much interest-bearing debt does the company have relative to the value of its assets?” This ratio, calculated as long-term debt divided by total assets, assesses the company’s degree of financial leverage. This is analogous to dividing the balance of a home mortgage (the long-term debt) by the appraised value of the home. A ratio of 1.0 would indicate no “equity in the house” and would reflect dangerously high leverage. Therefore, the lower the capitalization ratio, the better the financial leverage of the company.
Generally, the corporate bond investor buys additional yield by assuming credit risk. One should probably ask, “Does the extra performance increase the risk of failure?” or “Am I getting enough extra profit to take the implied risk?” In general, the higher the credit risk, the less likely you are to buy a single corporate bond issue outright.
In the case of junk bonds (ie, those rated below S&P’s BBB), the risk of losing your entire principal is simply too great. Investors looking for high yield can consider automatically diversifying into a high-yield bond fund, which can allow for little default while keeping yields high.
Investors should be aware of other risk factors affecting corporate bonds. Two of the most important factors are call risk and event risk. If a corporate bond is called, the issuing company has the right to buy (or pay off) the bond after a minimum period of time.
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If you own a high-yielding bond and prevailing interest rates fall, a company with a call option will want to call the bonds to issue new bonds at lower interest rates (in effect, to refinance its debt). Not all bonds are named, but if you buy one that is, it’s important to pay attention to the terms of the bond. It’s important to be compensated for delivering higher performing calls.
Event risk is the risk that a corporate transaction, natural disaster or regulatory change will cause a corporate bond to suddenly downgrade. Event risk tends to vary by industry sector. For example, if the telecommunications industry is consolidating, then the event risk may be high for all links in this sector. The risk is that the company holding the bond will buy another telco and possibly increase its indebtedness (leverage) in the process.
The reward for taking on all that extra risk is a higher return. The difference between the yield on a corporate bond and a government bond is called the credit spread (sometimes called the credit spread).
As the illustrated yield curves demonstrate, the credit spread is the difference in yield between a corporate bond and a government bond at any point in time to maturity. As such, the credit spread reflects the additional compensation that investors receive for credit risk. Therefore, the total return on a corporate bond is a function of the Treasury yield and the credit spread, which is higher for lower-yielding bonds. If the bond is called by the issuing corporation, the credit spread increases further, reflecting the additional risk that the bond will be called.
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Predicting changes in a credit spread is difficult because it depends on the specific corporate issuer and overall bond market conditions. For example, a credit upgrade for a particular corporate bond, say from an S&P rating from BBB to A, will reduce the credit spread for that particular bond because the risk of default decreases. If interest rates remain unchanged, the total yield on this “discounted” bond will fall by an amount equal to the reduced spread, and the price will rise accordingly.
After purchasing a corporate bond, the bondholder benefits from lower interest rates and a narrowing of the credit spread, which contributes to a lower yield to maturity on newly issued bonds. This, in turn, increases the price of the bondholder’s corporate bond. On the other hand, rising interest rates and widening credit spreads work against bonds, causing a higher yield to maturity and a lower bond price. Therefore, because narrowing spreads provide less continuous return, and because any widening of the spread hurts the bond’s price, investors should be wary of bonds with abnormally narrow credit spreads. Conversely, if the risk is acceptable, corporate bonds with wide credit spreads offer the prospect of a narrow spread, which in turn creates price appreciation.
However, interest rates and credit spreads can move independently. In terms of economic cycles, a slowing economy tends to widen credit spreads because companies are more likely to default, and an economy emerging from a recession tends to narrow the spread because companies are, theoretically less likely to default in a growing economy.
In an economy growing out of a recession, there is also the possibility of higher interest rates, which will cause Treasury yields to rise. This factor offsets the narrow credit spread, so the effects of a growing economy could produce a higher or lower total return on corporate bonds.
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If the additional return is affordable from a risk perspective, the corporate bond investor is concerned about future interest rates and credit spreads. Like other bondholders, they generally hope that interest rates will hold steady or, even better, fall.
They also generally hope that the credit spread will be flat or narrow, but not widen too much. Since the width of the credit spread is a major contributor to the price of your bond, be sure to evaluate whether the spread is too narrow, but also be sure to evaluate the credit risk of companies with wide credit spreads.
Require writers to use primary sources to support their work. These include white papers, government data, original reports and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we adhere to in producing fair and unbiased content in our editorial policy. The economic factors that influence corporate bond yields are interest rates, inflation, the yield curve and economic growth. Corporate bond yields are also influenced by company values such as credit rating and industry sector. All these factors influence the company’s bond yield and exert influence on each other.
The pricing of corporate bond yields is a multivariate and dynamic process in which there are always competing pressures.
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Economic growth, usually measured by GDP growth, is optimistic for corporations because it leads to increased revenues and profits for
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