The concept of corporate bonds is simple: companies issue bonds to finance their operations. There are two basic ways for a company to raise cash. It can sell a stake in itself by issuing stock; or it can take on debt by issuing bonds.
Investing in Corporate Bonds
There are two ways to invest in corporate bonds. First, you can buy individual corporate bonds through a broker. People who choose this route should research the financial fundamentals of the issuing company. You need to ensure you are not buying a bond that is at risk. While this is relatively rare, it should remain on your checklist.
If you purchase individual bonds, you want to make sure to diversify your portfolio sufficiently. This should include bonds from different companies, sectors, and various maturities.
The second option is to invest through mutual funds or exchange-traded funds (ETFs) that focus on corporate bonds. Funds carry a different set of risks compared to bonds. However, they also benefit from diversification and professional management.
You can use tools like Morningstar to compare funds and mutual funds. You also have the option to invest in funds that focus solely on corporate bonds issued by companies in developed and emerging foreign markets.
These funds carry more risk compared to their U.S. counterparts. But they also have the potential for higher returns in the long run.
How Can You Evaluate Corporate Bonds?
Corporate bonds are often evaluated by looking at the yield spread, or “yield spread,” relative to U.S. government bonds. U.S. government bonds are considered the benchmark because they are deemed risk-free.
High-rated companies can issue bonds with lower yields. They are financially strong and hold large amounts of cash on their balance sheets; these companies include names like Microsoft, Amazon, and Exxon. You can feel confident that these high-rated companies will not default on interest or principal payments.
On the other hand, lower-rated companies must offer higher yields to attract people to buy their bonds. These companies have higher debt or less reliable revenue streams. Investors, in turn, choose between a low-risk, low-return spectrum; or a high-risk, high-return spectrum. It all comes down to their goals. This is the classic risk-reward question you should consider during your research.
Investors can also choose between short-term, medium-term, and long-term corporate bonds. Short-term issues often pay lower yields. This is based on the idea that a company is less likely to default within three years than it would be over 30 years. This is because three years is a more certain timeframe than 30 years. Long-term bonds offer higher yields, but they are more volatile.
Investment managers aim for above-average returns along this spectrum. They might combine bonds with different maturities, yields, and credit ratings. This can help optimize returns and mitigate risk.
What Is the Risk Associated with Corporate Bonds?
Corporate bonds have seen very little default over time. High-rated bonds, in particular, have a very low chance of defaulting. Since 1981, bonds rated AAA have had an average default rate of 0%. Therefore, you can reduce risk by focusing on individual higher-rated bonds.
Bond funds and ETFs carry different risks. Unlike individual bonds, there is no fixed maturity date. There are two factors that can affect the performance of corporate bond funds. They are:
- Interest Rates
The prevailing yield: Corporate bonds are priced based on the yield spread against government bonds. This means that changes in government bond yields directly affect corporate issues. The yield on the corporate bond will also need to rise to maintain the spread. Remember that prices and yields move in opposite directions.
Conclusion
Over time, corporate bonds have provided strong returns. There isn’t much variation in those returns across small ETFs, even when considering risk. The corporate bond space offers a full range of options regarding finding the risk-return balance that suits you. Corporate bonds are a key component of a diversified portfolio aimed at generating sustainable income.
Source: https://www.thebalancemoney.com/the-basics-of-investing-in-corporate-bonds-417104
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