Adding corporate bonds to your portfolio can add stability and diversification, allowing you to earn good investments returns while moderating volatility. This article will help you learn more about corporate bonds and how to most effectively invest in to get the most bang for your buck.
Corporate bonds are simply loans to corporations. Investors loan their money to a corporation in exchange for periodic interest payments, and the promise that they will be given their money back after a set period of time.
If you are going to loan money to a corporation, you want to know that you are going to get your money back. Just a individuals have a credit score, corporations have a credit rating issued by at least one of several bond rating agencies. These agencies include S&P, Moodys, and Fitch. Each has a slightly different rating system, but essentially the ratings range from AAA (very unlikely to default) to BB (“junk” bonds), to D or F (currently in default).
The credit rating is important because it determines how high of an interest rate you should demand from the company. Since a AAA rated company is very unlikely to default, investors do not require a very high interest rate. Investors are not very concerned that a AAA rated company will lose their money. However, companies with very low credit ratings, sometimes called junk bonds, must pay a very high interest rate to compensate investors for taking on the risk that they may not get their money back.
Bonds have differing time period in which they ask to loan the money, generally ranging from as short as a few months to as long at 30 years. The time period of the loan also affects how high of an interest rate investors demand. Very short term loans to highly rated borrowers are considered very safe, so interest rates can be extremely low. Very long term loans are far more risky, because the credit quality of a company can deteriorate over time. For this reason, even companies that are rated AAA will have to pay a significant interest rate to investors to loan money for 30 years. This is because over the course of those 30 years, the company’s financial position might decline, or the company could go bankrupt.
Unless you have a very large sum to invest, it is wise for most retail investors to focus on investing in bond funds. This is because the bond market is far more complex and less transparent than the stock market. So even savvy stock investors may want a bit of professional oversight for a bond portfolio.
Also, investing in individual issues of corporate bonds often requires a significant investment in order to get good pricing on the bonds. The threshold is perhaps $50,000 or more per bond. Thus, in order to create even a basic diversified portfolio of 10 individual bonds, it would take $500,000 or more.
So, it often makes far more sense to pay a small expense ratio for a professional manager to oversee a portfolio of hundreds or thousands of bonds on your behalf.
Corporate bonds can be a great addition to your investment mix. By sticking with bond funds and choosing a credit quality and maturity in line with your risk and return preferences, you can get the most value from the bond portion of your portfolio.