Corporate Debt in Summary:
- Companies issue debt to investors to fund their operations and new investments, and offer a higher yield than Treasury and municipal bonds due to the increased risk the firm may have to declare bankruptcy.
- The primary source of return on a corporate bond is via semi-annual interest payments (which are taxed at your marginal tax bracket at the federal and state level).
- In the case of bankruptcy, debt-holders have seniority (aka first dibs) over stock investors to claim the leftover assets of the firm in order to attempt to get their money back.
- The value of a corporate bond is based on the general level of interest rates, the credit rating of the company and overall market interest rate associated with that credit rating.
- Due to large minimum required investments and trading costs associated with buying individual corporate bonds, the ideal way to invest in bonds is through a diversified and professionally managed bond fund. This would be an ideal investment for someone with a near-term goal within 3-5 years looking for a rate of return above cash equivalents on their money until then.
- Historically fixed-income investments have provided a lower return than stock ownership over the long-term, so corporate debt should not be a long-term investment option for young professional investors.
Debt issued by corporations represents the largest type of fixed-income market based on total bonds outstanding. Investors demand a higher return on their loans to companies since they are much more likely to default on their loans (i.e. failing to pay interest or return the original amount of money you invested when the loan expires/matures) when compared to Treasury and municipal debt. The form and function of corporate debt is similar to Treasuries in that the short-term debt is issued at a discount (if you give me $980 now I’ll give you $1,000 in a year), and longer-term debt offers a fixed coupon/interest payment every six months that provides investors a steady stream of fixed income.
When a company fails on their commitments to pay a bondholder coupons/interest on an outstanding bond or to return their original investment when the bond is due (matures), then the firm has defaulted. Usually, a firm then enters bankruptcy protection in order to determine how to pay off their current obligations and if they can restructure them. If there is no agreement on how to modify their existing loans, the firm must break up and sell their assets (buildings, inventory, goods, etc.) in order to return money to the parties that loaned them money.
An important feature of a bond is seniority – aka where do they fit in the line of who gets paid off first in the case of bankruptcy. Normally bank loans are given seniority and get their money back first, and whatever money is left begins to flow to bondholders. A study by rating agency Moody’s shows that in the case of bankruptcy, the average recovery rate received by senior unsecured bond investors from 1982-2010 was less than 40% – so if you invested $1,000 in a bond and the company went bankrupt then you, on average, will only get $400 back. That’s quite a loss! However stock investors in these companies that enter bankruptcy almost always receive nothing, thus showing the benefits of seniority in a bond. Different bonds within the same company may have differing seniority levels attached to them, where one type of bond will be paid out in full before the other type of bond receives any payments.
Now that we have seen the sizable losses associated with buying a bond in a company that later enters bankruptcy, it makes sense that the main concern of bondholders is whether the company will soon default on their loans. Credit rating agencies analyze companies and determine their ability to meet their commitments (to pay interest and return the original investment to bondholders), and assign companies an appropriate credit rating to help investors judge the probabilities that a company will default. Below is a table that describes the ratings by two major credit rating agencies Standard & Poors and Moody’s. It also provides the percentage of bonds that have defaulted on their repayments based on their original credit rating in the five-year period from 2010-2014 (according to Standard & Poors 2014 Ratings Direct Report):
|Standard & Poors||Moody's||Rating Description||S&P 5-Year Default Rate|
|AAA||Aaa||Highest Quality||0.0 percent|
|AA||Aa||High Quality||0.0 percent|
|A||A||Upper Medium||0.0 percent|
|B||B||Highly Speculative||8.0 percent|
|CCC, CC, C||Caa||Approaching Default||39.5 percent|
|D||Ca, C||Currently in Default|
- Bonds rated between AAA-BBB or Aaa-Baa are considered “Investment Grade” bonds. Bonds with a rating below these levels are considered “speculative,” and are often referred to as “junk bonds” due to their increased likelihood of some sort of default.
- Remember, once a company defaults on their bonds on average a bondholder receives about 40% of the original money they invested.
- Companies can receive differing marks within each category, seen as “+ or -” for Standard & Poors and “1, 2, or 3” for Moody’s.
So how is a bond’s price determined? Generally, there are three categories that determine a bond’s value:
- The market level of interest rates: Interest rates fluctuate on a daily basis based on supply and demand by investors for fixed income and many different economic indicators that are used to predict future interest rate levels. This generally plays out in the Treasury yield curve that we went over in the Treasury section. If interest rates on Treasuries rise, then the interest rate on all other bonds will likely rise accordingly. Prices on your bond and interest rates move in the opposite direction. So if your bond has an interest rate of 3% and the market level of interest rates rises to 4%, then your bond is less attractive compared to current interest rates and will become less valuable … thus dropping in price.
- The company’s credit rating: Based on the financial health of the company, investors will demand an extra payment for the risk they take on by lending the company money. This “spread” is the increase in interest rates above the benchmark Treasury. So if the 10-year Treasury is yielding 3.00%, and a strong company has a rating of AA, then investors will require a yield of, say, 4.00% on that company’s bond. If the company faces financial problems and is downgraded by the rating agency to BBB for example, then investors will demand a higher yield to compensate them for the extra risk of default. Investors will sell the bond, causing its price to drop, which will increase the yield so that same bond may now yield 5.00%. Since prices and interest rates move in the opposite direction, the value of your bond will decrease due to a credit rating downgrade (but the value will increase and the interest rate will decrease should the company’s credit rating be raised).
- The market’s credit rating spread: The final question of pricing a bond is what is the interest rate risk premium associated with each credit rating? In the above example, we showed a 10-year bond with an AA rating had a 1.00% premium to a 10-year Treasury bond (4% for the company bond versus 3% for the Treasury bond). However, this “spread” varies based on the current economic environment. At the height of the recession a company with an AA rating might have been seen as riskier, so the “spread” over a safe Treasury bond may have risen to 1.50% – thus resulting in a drop in the price of your bond due to the rise in interest rates (even with no change in the company’s credit rating!). The opposite has happened throughout the recovery as investors have seen firms as less risky, thus lowering the interest rate “spread” over Treasuries within each rating category … leading to a rise in prices of bond investments.
- The chart on the left shows an example of how a company bond relates to the Treasury yield curve. An “AA” rated company will have a yield above all Treasuries, while a lower rated “BBB” company will have to provide a yield even greater than the AA company due to their increased risk of default. If the AA company gets downgraded to BBB, then the yields on their bonds will go up and the prices of the bonds will go down to reflect the increased risk of default.
- The chart to the right shows an example of category #3 of when the spread associated with each rating increases. Notice the spread in yield to each line from the Treasury curve is greater, thus making the yield for each AA and BBB bond higher (if this happens then bond prices drop). When economic conditions worsen and all companies are seen as riskier than the yield curve would show something like this … causing bond prices to decline when yields rise.
As you are now likely cross-eyed and confused from trying to understand how to price these bonds, you will likely feel relieved to know that if you need to invest in fixed-income then you should pay someone else to do it for you!
If you want to buy an individual bond you must invest at least $1,000 each and pay transaction costs that can be as high as 2-5% of your investment. And you don’t want to just hold several bonds as you don’t want to risk the costly danger of one of your companies entering default! Due to the costs of trading and risks of being un-diversified, the best option here is to pay a professional manager to take your money and spread it across many different corporate bonds (and in many cases, the fund will buy many different types of bonds like Treasuries and mortgages as well for further diversification).
For investors that have a goal within 3-5 years that they need a set amount of money (such as for a down payment on a home), then investing in a fixed-income fund may be ideal.
Look for a fund that invests in highly-rated companies and bonds of a medium “duration” – or the length of time when the average bond in the fund comes due/matures. Buying bonds that mature in under seven years will have lower price volatility relative to longer-term bonds since they are more sensitive to interest rate movements.
Think of the example where if interest rates rise 1%: If you only have to wait one year to get your money back with a one-year bond then no big deal, you get a lower rate for one year and then you can reinvest your money at the higher rate. If you have to wait 30 years and you’re stuck with this lower rate for that long then that is brutal, and the price of your 30-year bond will drop much harder than the one-year bond. Also, look for a fund that charges no upfront fees (aka “no-load” funds) and has a low ongoing management fee (given as a percentage of assets in the fund).
Corporate bonds have historically provided the highest return on investment of the options we have reviewed thus far due to their increased risk of default.
Over certain periods, bonds have outperformed stocks due to their fixed-income features and relative increased safety. However, over long periods of time (which young investors face in our investment decisions) stocks have significantly outperformed bonds.
Therefore, corporate bonds (and other forms of fixed-income we have reviewed thus far) are not an appropriate long-term investment choice for investors with very long investment time horizons.