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Corporate Bonds: Risks and
Benefits
Life is risky. Every day investors are faced with complex
choices in the face of deep uncertainty. What to do? Look at
history and realize that the odds favor the educated. One
opportunity for learning comes in the form of corporate bond
offers.
Corporations raise funds in a variety of ways - income from
sales or services, straight bank loans and stock floats. One of
most common but least understood methods by the average
investor, though, is issuing bonds.
Essentially a loan by an investor to the company, like all
loans they have a due date (maturity) and an associated
interest rate (coupon). Maturities are typically less than ten
years and interest rates vary from nothing (zero coupons) to
higher than average market (high yield).
But, alas, nothing is without risk and where corporate bonds
are concerned it comes in several forms.
RISKS
Credit Risk
Some companies, like some individual borrowers, default on
their bonds. They may even continue in business afterwards and
investors are left with the choice of whether to sue or seek
other means of compensation.
Fortunately, Moody's and Standard & Poor's (as well as
other firms) rate credit risk on bonds according to often
highly reliable scales ranging from AAA (very low risk, but
usually low yield) to D (don't even think about it), with BB
considered junk range (risky, but high yield).
Interest Risk
Every bond is issued with some interest rate and some even
change over time. A relatively recent innovation, they're
called 'floaters' whose coupon rates vary with short-term or
other index measures. Sometimes those rates vary continuously
with market changes, some change in pre-set steps over the life
of the bond.
Since general interest rates can change, a bond purchased today
offering 5% is worth less if interest rates in general rise to
8% a year later. (An unusually high increase, but not unknown.)
The price of that bond will decrease for those wanting to sell
prior to maturity, and yield less over time than a newly
purchased bond for those thinking of holding until
maturity.
Risk and difficult choices are inseparable.
Maturity Risk
Some corporate bonds are issued with a proviso that they are
'callable'. I.e. they can be redeemed (usually at face value)
prior to maturity. Companies do this when interest rates fall,
and they wish not to continue making high interest payments to
bondholders. They can either pay back with available cash, or
with new bonds or bank loans, a form of corporate
're-financing' similar to that done by homeowners.
That callable feature represents the risk to an investor that,
though initially receiving high interest payments, they may not
be able to enjoy that same rate for the life of the bond. As a
consequence, those bonds are often discounted in some form to
compensate.
BENEFITS
High Yield
High yield bonds are just what the name suggests - they pay a
higher rate of return in exchange for perceived higher risk.
Not all fall into the category of 'junk' and savvy investors
have often profited handsomely from them.
Convertible Bonds
Convertibles offer investors the right to acquire a company's
common stock under specified conditions rather than by direct
purchase in the market. Newly issued convertibles usually have
a lower maturity (of 5 to 10 years) and offer a lower coupon
rate than that of nonconvertible bonds of comparable
quality.
Convertibles offer the potential for profiting from a company's
stock price appreciation, combined with the relative safety of
a bond. If the price of the underlying stock declines, the
bond's price normally falls only to a point where it yields a
decent return as a straight bond.
As with any investment, always do your homework. But don't be
turned away by the relatively higher complexity of bond
investing. Both the risks and returns of bonds are easier to
judge with confidence than many other investments, once an
investor climbs part way up that knowledge curve.
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