Risks

While there are 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 bond fundamentals 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.