With the current changes in the economy, most people may be wondering what investments they should make to grow their money and bring good returns. Corporate bonds are one of the investments that one can make. Just like any other type of bond, a corporate bond can be described as fixed-income security as it is a debt instrument whose interest payments are fixed usually at an agreed interest rate.
Corporate bonds are provided by corporations so that they can raise money to fund their projects, with their maturity date ranging from one year to even three decades.
They usually bring about a higher yield as compared to government bonds which are the bond issued by any administration to support its spending. Unlike administrative bonds, corporate bonds are highly risky. This bond can be categorized through the market sector that they manage or through the measures that they use as backing security.
These bonds can be either investment grade or non-investment grade. Investment-grade bonds get given by companies which are considered stable. Therefore they have a reduced chance of defaulting on the payment of their interest. While non-investment grade bond offering corporation has a low credit rating as they have a higher probability of default.
Bonds are usually rated first before they got offered as they give the prospective bondholder a gist of the risk involved.
Categories of corporate bonds
- Finance companies
- Public utilities
Each of the above categories should have a trustee. Most of us may be wondering why it is essential to have a trustee. Well, as mentioned earlier, there are some bonds which get backed up using security, which could be either an asset used as a mortgage or any other equipment. The trustees usually act as a third party between the corporation and the investor.
They are critical, especially when the investor may not be able to understand the terms of the contract. The trustee can be a bank or a trusted company that keeps track of the bonds sold and plays a crucial role in making sure that the investor’s interests are protected and taken into consideration.
If the bond defaults, the trustee can take action to protect the bondholder as per what the contract states. They are, however, paid by the bond issuer; hence they cannot investigate the corporation.
Why is it essential to invest in bonds that are backed by security?
- If there is a possible chance that the company might default then the investor will be at peace knowing that there is an asset acting as security and that they are protected.
- The investor is also at liberty to sell, for instance, the mortgaged property to settle the unpaid bond.
- There are also collateral trust bonds whereby instead of houses acting as security or any other fixed asset, the corporation offers the securities of the different companies that they own. These could be in the form of stocks, bonds or additional investment which they usually pledge to act as securities if they default.
These corporate bonds get also referred to as high yield bonds which have been rated by the rating agencies as being below investment grade. This term suggests that it has a higher risk of defaulting or could be facing bankruptcy soon, and there is no guarantee that the investors will get their interest.
However, it is not always true as some corporation usually pays off within the agreed date. Under this type of bond, there are three types of an issuer that are: The Original issuers, restructurings and leveraged buyouts and also the fallen angels.
The fallen angels’ issuers get represented by those having a debt that is in the investment-grade. However, over the years, they have faced many problems that have reduced their credit rating. The original issuers refer to the new companies that don’t have strong income statements; hence they sell their bonds with the promise of future profitability.
At the same time, the restructuring and leveraged buyouts are companies voluntarily increasing the debt so at to maximize the power of the shareholders. Therefore, the issuer of the bonds has a high debt burden; therefore, having a high default rate compared to the other bonds.
These type of corporate bonds as the name suggests they have been guaranteed payment by another company if the issuer will not be in a position to make payments. One needs to understand that there are some risks involved in this type of bond as the guarantor might also not be in a place to honour the guarantee contract.
These are bonds which are offered by corporations which have a strong credit rating; therefore, there is usually no securities attached to it. These bonds typically don’t have a high rate of interest. There are, however, some companies which offer this type of bond after they have already provided mortgage and collateral bonds.
Convertible debenture bonds
These bonds authorize the bondholder to convert the debenture bonds into shares in the company after a specified period. Most investors are attracted to this type of bond instead of the non-convertible debenture bonds.
These are bonds which corporations give to their investors and give them the liberty of claiming the assets of the company if the company fails to pay. These are usually at the front line ahead of lenders and shareholders. These senior bonds can be secured or unsecured. The secured one has security attached to it while the senior unsecured bonds don’t have the company’s asset attached to it in case of liquidation.
When investing in any type of bond, you must consider whether or not you are risk-averse. The conservative investors are those who are risk-averse and get usually advised to invest in short term corporate bonds. They are typically safe as a result of the short time required for the payment. Their maturities are generally one year to five years. They have a low risk, and their interest is little. The best corporate bonds to invest in this category are:
- The Vanguard short-term investment-grade fund
- The DFA quality portfolio.
- The iShares ETF.
- The fidelity bonds.
- Schwab index fund.
There are also medium-term bonds
Which mature between 5-12 years while long-term bonds grow from 12 to 30 years. For those interested in buying corporate bonds, they get usually advised to check on the credit spread.
Bringing out the comparison between the yield of a bond with the return of treasury bonds which have the same date of maturity and the market uses it as a way of knowing the health of the economy. The Treasury bond is mostly used as a benchmark since it has the lowest risk, and the bondholders get usually paid on the agreed time.
The Financial Conduct Authority (FCA) in the United Kingdom created to be independent of the UK government, and it protects the investors in any industry, including this sector.
It does this by regulating the activities of banks, financial advisers who happen to be independent and in societies. They can investigate any malpractices of the above entities and ban their activities if deemed to be of foul play to the investors.
Such a thing should put you at ease when considering the risks of investing in corporate bonds.
If you are looking for new ventures to invest in, you may consider investing in this type of bond. It is essential to know that the corporate bond market has ranked as the second-largest market in all other bond markets.
There are higher chances of getting more yield as compared to investing in different bonds, which can be low yielding and have a higher risk to incur.
You should also come up with investment management strategies that work for you once you have invested in corporate bonds.