Like other debt securities, the primary benefit of corporate debt (such as bonds) is interest income. While there are exceptions - such as commercial paper, which is typically issued at a discount (zero-coupon) - most corporate bonds pay interest semiannually.
Corporate bonds can also provide capital appreciation, especially when interest rates fall (bond prices generally rise when rates fall). However, interest rate movements are hard to predict, and bonds mature at par value. For that reason, most corporate bond investors focus on income rather than expecting capital gains. One important exception is convertible bonds: if the issuer’s common stock price rises significantly, the conversion feature can create an additional opportunity for gains.
Among the three major debt issuers (corporate, municipal, and U.S. government), corporate issuers generally carry the most risk. Companies do go bankrupt. For example, 70% of small businesses fail within their first decade. Because investors take on more risk with corporate debt, they typically receive higher yields as compensation. In general, the less established the company, the higher the yield investors may demand.
Even if an issuer defaults, bondholders have higher priority than stockholders in a liquidation. In addition, some corporate bonds may be secured or guaranteed, which can reduce (though not eliminate) credit risk.
Another benefit is the range of choices available in the corporate debt market. An investor could choose something relatively low-risk and low-yield, such as the lowest-ever yielding 3-year Amazon note. Or a more aggressive investor could pursue higher potential yields with a high-yield (junk) bond from a start-up or distressed issuer. This variety lets investors match corporate debt to their income goals and risk tolerance.
Corporate debt covers a wide range of risk profiles, but as a category it’s generally considered riskier than municipal or U.S. government debt. All of the risks discussed in the debt securities suitability chapter apply. Here’s a refresher of the key bond risks:
Systematic risks
Non-systematic risks
Because corporations go bankrupt more frequently than governments, default (credit) risk is a major concern with corporate bonds. Default risk is often highest with smaller or weaker issuers, but even well-known companies can fail over time. Examples include:
If you bought a 30-year bond from any of these issuers when they appeared strong, you could still have faced significant losses if the company later became insolvent. This is one reason default risk is especially important with long-term corporate bonds: the longer the time to maturity, the more time there is for an issuer’s financial condition to change.
The other bond risks apply in the usual way. When interest rates or inflation rise, bond prices tend to fall. Less actively traded corporate issues may be harder to sell quickly at a fair price, which increases liquidity risk. If the government changes regulations or tax treatment in a way that harms corporate issuers or investors, legislative risk becomes relevant.
Another practical risk involves taxes. Corporate bond interest is generally fully taxable at the federal, state, and local levels, and it’s taxed at the investor’s ordinary income tax rate (up to 37%). By comparison, qualified stock dividends may be taxed at 15% or 20%. That difference can make corporate bond interest less attractive on an after-tax basis, depending on the investor’s tax bracket.
A typical corporate bond investor is often an income-focused investor who’s willing to accept more risk than someone who buys only U.S. government or high-quality municipal debt. Because bonds can fluctuate in market value (due to interest rate changes, credit concerns, and liquidity), corporate debt investors need to be comfortable with price movement.
Corporate bond prices are generally less volatile than common stock, but they tend to be more volatile (on average) than bonds issued by municipalities or the U.S. government. Investors who allocate a large portion of their portfolio to bonds are often considered more conservative overall, but within the bond market, corporate debt is typically the riskiest major category. That means corporate bond investors should have at least some tolerance for risk.
The corporate market also offers a wide range of risk-and-return choices. For example:
An investor focused on preserving principal might accept the lower yield on an Apple bond. A more risk-tolerant investor might pursue the much higher yield offered by Gulfport Energy - while recognizing that a default could result in severe losses.
Like many bond investors, corporate debt investors are often older, but they’re typically willing to take on more risk than the average income-seeking investor. In corporate debt, the level of risk taken generally has a direct relationship to the yield an investor can expect.
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