Suitability

Benefits

Like all other debt securities, the primary benefit of corporate debt (like bonds) is interest income. While there are some exceptions for securities like commercial paper that are zero coupon, most corporate bonds pay semi-annual interest to investors.

Capital appreciation could occur with any debt security, especially when interest rates fall. However, interest rate fluctuations are difficult to predict and bonds ultimately mature at par. Most corporate debt investors do not expect capital gains from their securities. However, this is an added benefit provided to convertible bondholders if the issuer’s common stock price rises considerably.

Of the three major issuers (corporate, municipal, and US Government), corporate debt is the riskiest. Companies go through bankruptcy every year. In fact, 70% of small businesses fail within their first decade. While this isn’t the case for every business, corporate debt typically comes with higher yields due to the risk involved. The less proven the company, the higher yield an investor can expect.

Even if something goes wrong and the issuer defaults, bondholders have higher priority than stockholders during a liquidation. Additionally, corporate bonds could be secured or guaranteed, helping the investor avoid risk.

There’s a wide variety of options available to investors seeking corporate debt. One could invest in the lowest-ever yielding 3-year Amazon note, which presents little risk and return. Or, an aggressive and risk-tolerant investor could take their chances with a high-yielding junk bond from a start-up or distressed company. Variety and choices are important to investors, and the corporate debt market certainly offers them.

Risks

While there’s a wide variety of corporate debt risk profiles, it’s safe to assume they’re generally risky. All of the risks we discussed in the debt securities suitability chapter apply, sometimes with more emphasis on the risk. As a refresher, here are the bond risks to be aware of:

Systematic risks

• Interest rate risk
• Inflation (purchasing power) risk

Non-systematic risks

• Default (credit) risk
• Liquidity (marketability) risk
• Legislative risk
• Political risk
• Reinvestment risk
• Call risk

Because corporations go bankrupt at a much greater frequency than governments, you can assume corporate securities are very subject to default risk. While default risk is most significant with smaller, less successful companies, there’s a long history of companies that were largely successful at one point in time, but eventually claimed bankruptcy. This includes:

• Lehman Brothers
• Worldcom
• Enron
• Chrysler
• Washington Mutual (WaMu)

If you bought a 30-year bond from any of these companies when they were at their peak, you would’ve lost a considerable amount of money. Nothing is certain in finance, and even titans of industry can become insolvent. Default risk is a considerable risk to take on, especially with long-term bonds. Who knows what will happen by the time the bond matures?!

All of the other risks apply as they normally do with bonds. When interest or inflation rates rise, bond prices fall. Less desirable corporate bonds may face liquidity risk. If the government threatens to regulate or tax corporate debt unfavorably, legislative risk applies.

Another risk to be aware of relates to taxes. Corporate bonds are fully taxable (federal, state, and local taxes), plus the tax rate on interest is equivalent to the bondholder’s income tax bracket (up to 37%). As compared to dividends from stock, which are taxable at 15% or 20%, taxes on corporate interest income are high. This is something to keep in mind prior to making a corporate debt investment.

Typical investor

The typical investor in a corporate debt security is usually a more aggressive investor seeking income. Given the risks that securities like bonds present (interest rate risk, default risk, etc.), corporate debt investors need to be comfortable with market price fluctuations. Corporate bond market prices are less volatile than common stock, but they’re more volatile (on average) than other debt issuers like municipalities and the US Government.

Investors that place large portions of their portfolios in bonds are still on the conservative (safe) side of investing, but corporate securities are the riskiest within the world of debt. Therefore, corporate debt investors need to be somewhat tolerant of risk at the very least. Of course, there’s a wide range of risk profiles to choose from. For example:

• Apple offers 3-year notes at 0.75%
• Gulfport Energy bonds trading a yield of 52.5%

If an investor wanted to keep their money safe, they could settle with the low-yielding Apple bond. If a risk-tolerant investor wanted to take a chance, they could buy the Gulfport Energy bond with a potential return of 52.5%. Of course, the bond could be worth nothing if Gulfport goes bankrupt. This is a great example of the variety of risk profiles in the corporate debt market.

Like most bond investors, corporate debt investors are generally older, but are willing to take on more risk than the average income-seeking investor. The amount of risk they face relates directly to their overall rate of return.