When you buy shares of stock, you own a piece of a company; when you buy corporate bonds (or corporates, as they’re also known), you are lending the company money for a specified amount of time and at a specific rate of interest. While corporate bonds are riskier than government or municipal bonds, long-term corporate bonds have outperformed their government and municipal counterparts over the past fifty years.
Unlike the U.S. government, however, companies can—and do—go bankrupt, which can turn your bond certificates into wallpaper. Kmart, Blockbuster, and Enron are all examples of large companies that have declared bankruptcy. There- fore, the risk of default comes into play with corporate bonds.
Corporates are generally issued in multiples of either $1,000 or $5,000. While your money is put to use for anything from new office facilities to new technology and equipment, you are paid interest annually or semiannually. Corporate bonds pay higher yields at maturity than various other bonds—though the income you receive is taxable at both the federal and state level. If you plan to hold onto the bond until it reaches maturity and you are receiving a good rate of return for doing so, you should not worry about selling in the secondary market. The only ways in which you will not see your principal returned upon maturity is if the bond is called, has a sinking-fund provision, or the company defaults.
A call will redeem the bonds before their stated maturity. This usually occurs when the issuer wants to issue a new bond series at a lower interest rate. A bond that can be called will have what is known as a call provision, stating exactly when the issuer can call in their bond if they so choose. A fifteen-year bond might stipulate that it can be called after eight years. Reinvesting in a bond that has been called will usually involve lower rates. Since the call will change the mathematics, your yield to maturity won’t be the same.
A sinking-fund provision means that earnings within the company are being used to retire a certain number of bonds annually. The bond provisions will indicate clearly that they have such a feature. Each year enough cash is available, a portion of the bonds will be retired, which are usually chosen by lottery. Whether the bonds you’re holding are selected is merely the luck of the draw.
Unlike a call provision, you may not see anything above the face value when the issuer retires the bond. On the other hand, since the company uses money to repay debts, these bonds likely won’t default, making them a lower-risk investment. There are a few other reasons why bonds can be called early, and those are written into the bond provisions when you purchase them. As is the case when you buy any investment, you need to read everything carefully when buying bonds. There are numerous possibilities when it comes to bonds and bond provisions. Again, read all bond provisions very carefully before purchasing.
Known in the financial world by their official name, high-yield bonds, but known to many investors as junk bonds, these bonds can provide a higher rate of return or higher yield than most other bonds. Junk bonds are risky investments, as investors saw in the 1980s debacle involving Ivan Boesky and Michael Milken. These two infamous financiers brought an awareness of junk bonds to the mainstream when their use of this risky debt to finance other endeavors came crashing down.
The “junk bond kings” issued debt with nothing backing it up. When it came time to pay up, the money just wasn’t there, and investors were left holding worthless pieces of paper—hence the term junk bonds. High-yield bonds are bonds that didn’t make the grade. They are issued by companies that are growing, reorganizing, or are considered at greater risk of de- faulting on the bond, for whatever reason.
These bonds are often issued when companies are merging and have debts to pay in such a transaction. They are used as a method of financing such acquisitions. High-yield or junk bonds include the risk of default and the risk that their market value will drop quickly. Since the companies that issue these bonds are not as secure as those issuing high-grade bonds, their stock prices may drop, bringing the market value of the bond down with it. This will mean that trading such a bond will be-come very difficult, therefore eliminating their liquidity.
Before the 1980s, most junk bonds resulted when investment-grade issuers experienced a decline in credit quality, brought on by big changes in business conditions or when they took on too much financial risk. These issuers were known as fallen angels.
Sometimes a company begins by issuing lower-grade high-yield bonds and does well, with their sales numbers going up. Eventually, this company reaches a level at which they can issue higher-grade bonds. This means that in the short term, you can receive high yields from their original low-grade bonds. It also means that they will call the bonds as soon as they are able to issue bonds at a lower yield.
If you see a company with great potential that has not yet hit its stride, perhaps you will want to take a shot at a high-yield bond from that company. If you are not that daring, you might opt for a high-yield bond mutual fund, which diversifies your investment so that you are not tossing all your eggs into one high-risk basket. In this manner, if one company defaults, you are still invested in others in the fund, some of which may prosper.
A popular bond category since the 1980s, mortgage-backed securities (MBS) can be a highly profitable, extremely complicated, and highly risky investment option. The keyword here, though, is complicated, and the intricacies of some of these securities (particularly the CMO, or collateralized mortgage obligation, variety) make them inappropriate for novice investors. In fact, they were largely implicated in the big financial meltdown of 2008.
But the most basic form of these bonds, the MBS, can make a good addition to an income-focused portfolio. Financial institutions help create mortgage-backed securities by selling part of their residential mortgage portfolios to investors. Investors basically buy a piece of a pool of mortgages. An investor in mortgage-backed security sees profit from the cash flow (people’s mortgage payments) generated from the pool of residential mortgages.
As mortgage payments come in, interest and principal payments are made to the investors. There are several types of mortgage-related securities available today. One of the most common is the pass-through Ginnie Mae, issued by the Government National Mortgage Association (GNMA), an agency of the federal government. The GNMA guarantees that investors will receive timely interest and principal payments. Investors receive potentially high-interest payments, consisting of both principal and interest. The rate of principal repayment varies with current interest rates.
Choosing Bonds for Your Portfolio
One of the keys to successful bond investing is diversification. Holding a range of maturities—a strategy commonly called laddering—helps ensure your portfolio won’t take too big a hit when interest rates go wild. Your bond ladder should have an average maturity that meshes with your overall financial plan—and that helps diversify your portfolio as a whole.
In addition, holding bonds with different risk characteristics can increase your returns with a margin of safety. As you’re deciding which bonds to buy, there are several more personal issues you’ll need to consider. Taxes are first on the list. Some bonds, mainly government bonds, offer some tax advantages that may be very attractive to someone in a higher tax bracket. At the same time, though, holding tax-exempt bonds could cause the alternative minimum tax rules to kick in, increasing your tax bill. Another factor to consider is your inflation situation: If the rest of your income is relatively safe from the negative effects of inflation, you may not have to make risky bond choices to stay ahead.
Generally speaking, most people do best when the bulk of their bond investments are high quality, meaning treasuries, munis, and high-grade corporate bonds. Mixing these three types together is better than focusing on only one. These types of debt securities balance out the risk of the stock portion of your portfolio in a way that junk bonds cannot. And investors looking for big returns may be better off allocating a little more to the stock market than investing in high-risk, high-yield bonds.
Improve Trading Skills with Daily Investment
Learn how to trade – or develop your knowledge in economy – with free online courses, advice and consultancy. All from an expert team with many years’ experience in the finance and business. Learn at your own pace with useful, step-by-step lessons in detail – including videos, interactive exercises and documentaries to help you check your understanding. CFDs are complex, high risk and losses can be substantial.