Corporate bonds

Corporate bonds are bonds issued by corporations of sufficient credit quality to be considered investment-grade (i.e. excludes High Yield/"Junk" bonds).

Interest rate risk
The most common model for thinking about corporate bonds is that they pay a premium on top of the risk-free rate (represented by ultra-short-term default-risk-free assets like Treasury Bills) for assuming other risks. One of those risks is shared with Treasuries of similar duration: interest rate risk.

Credit risk
Although legally bondholders must be paid before stockholders, there is nevertheless the risk that a company could default on its loans, triggering bankruptcy proceedings. This risk varies with the credit rating of the bond.

Call risk
Many corporate bonds include call options which allow the issuer to buy back the bond at face value under certain conditions. This is most likely to occur if market rates fall or if the issuer's credit rating improves substantially, limiting the extent to which the investor can profit from these otherwise favorable occurrences. This negative convexity is generally far smaller than the negative convexity experienced by  mortgage-backed bonds.

Role in a portfolio
According to Boglehead and financial guru Larry Swedroe, "the evidence shows that corporate bonds have provided very similar returns to Treasuries (credit risk has not been rewarded appropriately)." (Source: first comment of Alan Roth's article ). Swensen also argues for only including Treasuries in a portfolio.

Other experts, including the authors of the Bogleheads' guides, routinely recommend Vanguard's Total Bond Market fund, which includes a hefty portion of investment-grade corporate bonds.

As with many situations, there is probably no right answer to the question of whether or not to include corporate bonds in your allocation. Including them is certainly a perfectly reasonable thing to do, and can add higher yield, albeit at the cost of increased correlation with the equity component of your portfolio.

Unless you have an extremely large portfolio the preferred way to invest in corporate bonds is via a bond fund. While some investors prefer to hold bonds directly, for corporate bonds the loss in diversification as compared to a fund makes that choice ill-advised. A bond fund typically holds thousands of bonds, which diversifies away the un-systematic risk of individual issuers defaulting. It would be difficult to hold even a tenth as many bonds in all but the largest individual portfolios, leaving bondholders exposed to risk they are not rewarded for taking.

Links

 * About Corporate Bonds SIFMA InvestinginBonds.com