Risks

While corporate bonds can have many different risk profiles, it’s generally fair to treat them as riskier than government debt. The same bond risks covered in the bond fundamentals chapter apply here, and some of them - especially default risk - tend to matter more. As a refresher, here are the bond risks to keep in mind:

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

Default risk is a major concern with corporate bonds

Corporations go bankrupt far more often than governments, so corporate bonds are especially exposed to default (credit) risk. Default risk is often highest with smaller or financially weaker companies, but it can also show up in companies that once looked very strong.

There’s a long history of well-known firms that were successful for a time and later filed for bankruptcy, including:

• 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 could’ve lost a considerable amount of money. In finance, nothing is guaranteed - even large, well-known companies can become insolvent. That’s why default risk is a major tradeoff, especially with long-term corporate bonds: a lot can change before maturity.

Other bond risks still apply

The rest of the bond risks work the same way they do for any bond:

• When interest rates rise, bond prices fall.
• When inflation rises, bond prices tend to fall, and the bond’s fixed payments lose purchasing power.
• Less desirable corporate bonds may be harder to sell quickly at a fair price, creating liquidity (marketability) risk.
• If the government threatens to regulate or tax corporate debt unfavorably, legislative risk applies.

Tax treatment is another important consideration

Corporate bond interest is generally fully taxable at the federal, state, and local levels. The tax rate on interest is the bondholder’s ordinary income tax rate (up to 37%).

By comparison, stock dividends may be taxed at 15% or 20%. That difference can make corporate bond interest income relatively tax-inefficient, so it’s worth considering the after-tax return before investing.