Corporate bonds are investments in debt that a company issues that get sold to investors. This process allows the organization to get the cash it needs immediately while the investor receives an established number of interest payments. Once the bond expires, then the investor gets their original investment returned and it closes.
The backing for corporate bonds is generally based on the payment ability of a company. Outcomes are also dependent on its future revenues. There can be times when the physical assets of the company are used as collateral to secure investments.
When considering the advantages and disadvantages of corporate bonds, this investment option is typically seen as a low-risk venture. Investors who want to build a balanced portfolio add bonds because they offset less-conservative choices. Once capital accumulates, then more bonds and fewer high-risk ventures become part of the investment package. Retirees can also invest their assets in bonds as a way to supplement their income.
List of the Advantages of Corporate Bonds
1. Corporate bonds provide strong returns.
One of the significant advantages of corporate bonds is the robust returns that they offer to investors. Yields on some government bonds hover around 2% in the United States, with other governments sometimes offering items less than 1% in some situations. When you look at the return on a corporate bond, you’ll typically receive 4% to 5% – and sometimes more, if you’re willing to take on a little risk with this investment.
2. Investors receive a high liquidity level with corporate bonds.
Most corporate bonds are tradable in the secondary market. That means investors have the option to buy or sell these securities after an organization issues them. It is a benefit that allows investors to benefit from a sale when it rises in price. You also have the ability to buy bonds to add to a portfolio after the price deadline expires.
3. Several options are available in the market for corporate bonds.
Investors can find several different corporate bond types available for selection when choosing this option to add to their portfolio. Short-term bonds typically have a maturity rate that is 5 years or less. If a medium-term bond receives selection, then it can mature somewhere between 5 to 12 years. Long-term options that go to 30 years or further are also possible. That’s why it is essential to review what the coupon structure of the investment product is before finalizing the transaction.
If a bond comes with a zero-coupon rate, then the company isn’t going to make any interest payments on that product. These get issued at a discount to their par value instead.
4. You get to pick the coupon structures that work the best for your portfolio.
Corporate bonds give you the option to pick your preferred coupon structure when shopping for an investment product. Floating coupon rates get benchmarked against acceptable indices, such as the London Interbank Offered Rate (LIBOR). Then the payments change according to the movement of the benchmark. Step coupons are another choice where investors receive a higher interest payment with each date.
5. Corporate bonds typically have better yields.
Although corporate bonds are a riskier investment when compared to government, municipal, or other types, the historical yield of this product is also better. When your bond comes from a reputable company, you can still sell it on the secondary market to realize a profit and get cash-in-hand even when interest rates fall. You also get to pick from different levels of risk to work with the yield you want to achieve with your investments. Introducing lower-quality bonds into your portfolio can add another layer of diversification that can help to manage your income.
6. This investment option is a certainty investment.
One of the best reasons to consider corporate bonds is the high levels of certainty that are available with regard to the interest payments. You know that you’ll have a high chance of receiving a payment when the due date arrives. It’s like how you pay a monthly rate when you have a car loan with some of the interest included each time, except in reverse. You might even receive dividend payments or other benefits at the discretion of the organization, further improving the financial benefits of this option.
7. Investors rank higher when holding bonds instead of stock.
If the organization issuing corporate bonds goes into bankruptcy for any reason, then the judicial system typically ranks bondholders higher than shareholders when distributing payments to creditors. The bond is technically a debt that gets repaid, whereas the shares are considered equity in the firm. That means you have a better chance as an investor to recover some of your initial purchase if the agency decides to liquidate.
8. The pricing structure of corporate bonds is predictable and stable.
Although the price of a corporate bond will rise or fall based on interest rates and demand, you don’t see the same daily fluctuations in value as you do with shares and other investments. It is much easier to predict what the outcome will be when adding this item to your portfolio, especially with the availability of structured coupons and other potential benefits. It may not be suitable for those who want to grow their wealth quickly, but this option is a low-risk way to create another stream of income or diversify a portfolio effectively.
9. Some organizations may convert bonds into stock.
One of the ways that a company can pay off the debt from the issuance of corporate bonds is to transition that responsibility into equity shares. This outcome adds more risk to the portfolio of the investor, but it also creates an asset that can get sold immediately at the current value the marked priced for the asset. When using this option carefully, it can lead to a significant amount of profits that can get reinvested into other assets as time passes.
List of the Disadvantages of Corporate Bonds
1. Some corporate bonds are thinly traded.
Some corporate bonds don’t receive much attention in the secondary market. If an investor puts money into one of these options, then they might get locked into a long-term product that adversely impacts the health of their portfolio. Numerous variables can impact this transaction and potential disadvantage, including the credit rating of the bond, the size of the investment position, and the interest rate the bond offers.
The amount of money put into the bond is also part of this disadvantage. When bonds with high face value are in an investor’s portfolio, then they can be just as challenging to move as having one issued by a small, less financially stable company.
2. Credit risk is a significant problem for corporate bonds.
If the issue of a corporate bond goes out of business, then it is possible for the investor to lose their money and the option to receive the intended interest payments. That’s a significant risk factor when compared to the bonds that a government issues with a higher credit rating. Since a government can raise taxes to fulfill its obligations, the lower returns are sometimes worth the reduction of risk because of this issue.
That’s why every investor should review all of their options and speak to a qualified financial advisor before finalizing their decision on corporate bonds. Some companies have a AAA rating, but there are also options on the market that have a C rating or lower.
3. Event risk is another notable issue with corporate bonds.
Companies can sometimes face unforeseen circumstances when their ability to generate cash flows would get impeded. The interest payments from the corporate bonds associated with the product are sometimes based on the ability to create liquidity. If there isn’t enough money available from one-time events or unforeseen circumstances, then the investment product may not be as valuable over the long term as other options.
4. You must monitor the risk of your corporate bonds.
Many investors choose to purchase their corporate bonds through a brokerage firm. It’s a simple and easy way to add this investment product to a portfolio, especially with the online trading mechanisms that are available today. If you choose this option, then it is up to you to monitor the risk of the bonds that you decide to buy. Your financial advisors or brokers cannot and will not take on this responsibility for you.
If you want more automation to your investment choices or need someone to manage the results on your behalf, then mutual funds might be a better solution.
5. Investors face an interest rate risk when investing in corporate bonds.
When interest rates start falling, then the price of corporate bonds in the marketplace will generally rise. The opposite effect also occurs. This happens because investors want to try to capture or lock in the highest rates possible for the longest time available. It is a technique that attempts to purchase every available bond that pays at a higher rate than what the current market rate is for the economy. The rise in demand causes an increase in prices.
When the current interest rates are going up, then investors try to get rid of their low-interest products. That action floods the secondary market with bonds that a lot of people don’t want, and this activity causes the prices to do downward.
6. Investors must choose corporate bonds wisely to create diversification.
Many of today’s largest companies have hundreds, if not thousands, of different brands that can be wholly-owned subsidiaries of the parent organization. Some of them can even be organizations authorized to issue corporate bonds. If you own shares of PepsiCo as an investor and purchase bonds issued by Beaman Bottling Company, then the diversification wouldn’t happen because both products go through the same structure. That’s why it is imperative for an investor to perform their due diligence before finalizing a decision about pursuing this investment option.
7. Your initial investment could lose value.
Inflation impacts the value of money that you hold. If you had $20,000 in the 1970s, that money could go a lot further than what it can purchase today. When investors decide to purchase medium- or long-term bonds, then the interest payments that come in during this time must be enough to make up for the loss of value that occurs with the initial investment. It is entirely possible for someone to lose money with a corporate bond even when every payment gets received on time because the interest rates don’t match up with the rise of inflation.
8. You must have a larger sum of money available as an investment.
Although investors can purchase some corporate bonds for as little as $1,000, most of them require a significantly higher amount of money to get involved with this investment option. That means the cost of getting started with portfolio diversification in this manner could be out of reach for some beginner investors. If you find yourself in this situation, then it may be better to look at a Certificate of Deposit to grow your money. They are typically offered at lower entry rates and can sometimes offer a return that’s similar to the amount that you’ll receive from a corporate bond.
Most investors look at corporate bonds as a reasonably safe investment during times of economic turmoil. Governments tend to reduce interest rates on the ultra-conservative products in a portfolio at this time, which means this product can offer an interest rate that’s two or three times the going rate because of the added level of risk.
If you want your money to grow quickly as an investor, then corporate bonds won’t make that outcome happen. The best way to use this investment option is to purchase enough to offset the riskier investments that you keep in your portfolio.
When looking at the advantages and disadvantages of the corporate bond, it is essential to remember that you’re essentially lending your money to the business that sold this investment product. That means you must abide by the terms and conditions of the agreement. There are always risks associated with this activity, even with conservative options, so speak with your financial advisor about the benefits and pitfalls that may apply in your specific situation.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.