Although we at CGL Financial are not licenced to sell or advise on individual bond investments we can advise you on various mutual funds that have a weighting in bond and other fixed income investments. Consequently we believe it is important to have an understanding of how a bond works. The following is a useful primer on the workings, risks and advantages of owning bonds via a mutual fund that may contains various kinds of bonds. If you wish to own individual bond securities please consult a stock broker or other qualified professional.
What is a Bond?
Government and Corporate bonds are debts issued by governments, industrial, financial and service companies to finance capital investment and operating cash flow. In terms of total value of bonds issued the corporate bond market is much bigger than each of the markets for municipal bonds, U.S. treasury securities, and government agencies securities. Investors in corporate bonds have a wide range of choices when it comes to bond structures, coupon rates, maturity dates, credit quality and industry exposure.
This section provides information on investing in corporate bonds, including:
- Different types of corporate bonds, including high yield bonds and fixed rate capital securities
- What happens when a corporate bond issuer goes bankrupt
- How changes in a company’s credit rating can affect its bond investors’ yields
Corporate bonds (also called corporates) are debt obligations, or IOUs, issued by private and public corporations. They are typically issued in multiples of $1,000 and/or $5,000. Companies use the funds they raise from selling bonds for a variety of purposes, from building facilities to purchasing equipment to expanding their business.
When you buy a bond, you are lending money to the corporation that issued it. The corporation promises to return your money (also called principal) on a specified maturity date. Until that time, it also pays you a stated rate of interest, usually semiannually. The interest payments you receive from corporate bonds are taxable. Unlike stocks, bonds do not give you an ownership interest in the issuing corporation.
Benefits of Investing in Corporate Bonds
Investors buy corporates for a variety of reasons:
- Attractive yields. Corporates usually offer higher yields than comparable-maturity government bonds or CDs. This high-yield potential is, however, generally accompanied by higher risks.
- Dependable income. People who want steady income from their investments, while preserving their principal, may include corporates in their portfolios.
- Safety. Corporate bonds are evaluated and assigned a rating based on credit history and ability to repay obligations. The higher the rating, the safer the investment as measured by the likelihood of repayment of principal and interest. (See Understanding Credit Risk below.)
- Diversity. Corporate bonds provide an opportunity to choose from a variety of sectors, structures and credit-quality characteristics to meet your investment objectives.
- Marketability. If you must sell a bond before maturity, in most instances you can do so easily and quickly because of the size and liquidity of the market. (See Marketability below.)
All bonds are debt securities issued by organizations to raise capital for various purposes. When you buy a bond, you lend your money to the entity that issues it. In return for the loan of your funds, the issuer agrees to pay you interest and ultimately to return the face value (principal) when the bond matures or is called, at a specified date in the future known as the “maturity date” or “call date.”
High-yield bonds are issued by organizations that do not qualify for “investment-grade” ratings by one of the leading credit rating agencies—Moody’s Investors Service, Standard & Poor’s Ratings Services and Fitch Ratings. Credit rating agencies evaluate issuers and assign ratings based on their opinions of the issuer’s ability to pay interest and principal as scheduled. Those issuers with a greater risk of default—not paying interest or principal in a timely manner—are rated below investment grade. These issuers must pay a higher interest rate to attract investors to buy their bonds and to compensate them for the risks associated with investing in organizations of lower credit quality. Organizations that issue high-yield debt include many different types of U.S. corporations, certain U.S. banks, various foreign governments and a few foreign corporations.1
Understanding Credit Risk
A bond issuer’s ability to pay its debts—that is, make all interest and principal payments in full and on schedule—is a critical concern for investors. Most corporate bonds are evaluated for credit quality by Standard & Poor’s, Moody’s Investors Service and Fitch Ratings. (See their rating systems in the chart below.) Checking a bond’s rating before buying is not only smart but also simple: Just ask your financial consultant.
Bonds rated BBB or higher by Standard & Poor’s and Fitch Ratings, and Baa or higher by Moody’s, are widely considered “investment grade.” This means the quality of the securities is high enough for a prudent investor to purchase them.
How quickly and easily a particular bond can be bought or sold determines its marketability. To the extent the term “marketability” is used interchangeably with “liquidity,” it also implies that the price of the security will not change much under normal market conditions. In general, for a bond to enjoy high marketability, there must be a large trading volume and a large number of dealers in the security.
Understanding Interest Rate Risk
Like all bonds, corporates tend to rise in value when interest rates fall, and they fall in value when interest rates rise. Usually, the longer the maturity, the greater the degree of price volatility. If you hold a bond until maturity, you may be less concerned about these price fluctuations (which are known as interest-rate risk, or market risk), because you will receive the par, or face, value of your bond at maturity.
Some investors are confused by the inverse relationship between bonds and interest rates—that is, the fact that bonds are worth less when interest rates rise. But the explanation is essentially straightforward:
- When interest rates rise, new issues come to market with higher yields than older securities, making those older ones worth less. Hence, their prices go down.
- When interest rates decline, new bond issues come to market with lower yields than older securities, making those older, higher-yielding ones worth more. Hence, their prices go up.
As a result, if you have to sell your bond before maturity, it may be worth more or less than you paid for it.
Various economic forces affect the level and direction of interest rates in the economy. Interest rates typically climb when the economy is growing, and fall during economic downturns. Similarly, rising inflation leads to rising interest rates (although at some point, higher rates themselves become contributors to higher inflation), and moderating inflation leads to lower interest rates. Inflation is one of the most influential forces on interest rates.
Many investors who want to reap the good returns available in the corporate bond market buy shares in bond mutual funds instead of individual bonds—or in addition to individual bonds. They do so for the same reasons investors have flocked to mutual funds of all kinds in recent years—diversification, professional management, modest minimum investments, automatic dividend reinvestment, and other convenience features.
Diversification is an especially important advantage of bond funds. Many investors in individual bonds buy only a few securities, thus concentrating their risk. A fund manager, by contrast, spreads credit risk, interest-rate risk and, indeed, all other kinds of risk, over many bonds. Different issuers, sectors, credit ratings, coupons and maturities are all represented in a diversified portfolio.
However, lower risk does not mean no risk. All the underlying risks that affect bonds affect bond funds—but not as sharply. You should be aware that prices of bond fund shares fluctuate inversely with interest rates, just as individual bonds’ prices do, and when you sell fund shares, they may be worth more or less than you paid for them.
Corporate Bonds Glossary
Collateral - Assets pledged by a borrower to secure repayment of a loan or bond.
Coupon - A bond’s stated interest rate.
Default - A borrower’s failure to make timely payments of interest and principal when due or to meet other requirements related to the bonds, such as maintenance of collateral or financial covenants.
Face value - The value that appears on the front, or face, of a bond, which represents the amount the issuer promises to repay at maturity. Also known as par or principal amount.
Interest - Compensation paid or to be paid for the use of money, generally expressed as an annual percentage rate. The rate may be constant over the life of the bond (fixed-rate), or may change from time to time by reference to an index (floating-rate).
Liquidity - Capacity of a market to absorb a reasonable level of selling without significant losses.
Maturity - The date when the principal amount of a bond becomes due and payable.
Security - Collateral pledged by a bond issuer (debtor) to an investor (lender) to secure repayment of the loan.
Volatility - The propensity of a security’s price to rise or fall sharply.