Corporate bonds

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

Risks

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.

Corporate bond types

Corporate bonds are often broadly classified into 5 groups:[1]

  1. Utilities: Bonds issued by companies which provide a public utility such as power or water.
  2. Transportation: Bonds issued by companies such as railroads and airlines.
  3. Industrials: This is the group where companies which do not fit cleanly into the other 5 groups are categorized and is therefore the largest and most diverse group. It includes bonds ranging from those issued by GE to IBM.
  4. Finance: Bonds issued by companies such as banks and insurance companies.
  5. Yankee Bonds: Bonds issued by foreign companies which are denominated in US Dollars. Foreign companies issue Yankee bonds in order to attract US buyers.

Taxation

Interest and capital gains from corporate bonds are taxable at both the state and federal level. This is in contrast to treasury bonds, which are taxable at the federal but not state level, and municipal bonds which can often be exempt from both state and federal taxes. Investors should therefore take their individual tax situation into account when evaluating corporate bonds vs. other types of bonds.

Corporate bond prices

Brokers are required to report their corporate bond trades to FINRA within 15 minutes of the trade.[2] TRACE (Trade Reporting and Compliance Engine) is FINRA’s system for collecting and distributing bond price data. Access to TRACE is freely available to individual investors and can be found here (enable browser cookies to view). Many online brokers now offer real time electronic access to executable bond prices as well.

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)." [3]. 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. In a September 2012 interview[4] John Bogle also commented on the attractiveness of corporate bonds at that time.

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.

References

  1. Thau, Annette (2012). The Bond Book. The McGraw Hill Companies. pp. 173.
  2. Reporting of Corporate and Agencies Debt Frequently Asked Questions, FINRA
  3. Source: first comment of Alan Roth's article
  4. Bogle: Buy Corporate Bonds With Rates Low, indexuniverse.com

External links

Further reading

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