Investors buy corporate bonds for various reasons: attractive and predictable returns, dependable income, flexibility, and diversification. Corporate bonds are debt obligations issued by U.S. and foreign companies to raise capital for business growth and general corporate purposes. Most are unsecured promises to repay the principal at a predetermined future date, although some bonds may be secured by a first mortgage or other assets. The issuing company also agrees to pay interest to compensate investors for lending their money. Unlike stocks, which represent ownership in a company, bonds are obligations of the issuer to pay back the borrowed funds. Hence, the bondholders have priority over the stockholders to be paid interest and principal prior to any dividend distributions.
BENEFITS OF CORPORATE BONDS
Predictable Income Most corporate bonds offer fixed interest payments for the life of the bond, which may be paid semi-annually, quarterly, monthly or at maturity. Interest rate and payment frequency are set at the time of issuance so investors always know when and how much to expect. This is especially beneficial for retirees and other investors looking to supplement their current incomes.
Competitive Returns Since corporate bonds are considered riskier than other fixed income investments, such as Treasury bonds, they generally offer higher yields. In addition, yields vary among corporate bond issuers based on different risk factors, including an issuer’s creditworthiness and its industry. Economic factors and changing market conditions may have a greater effect on some industries than others. Corporations and industries perceived to have more risk will have to offer higher yields to gain access to capital markets. Corporate bonds present investment opportunities for many levels of risk tolerance. Therefore, investors and their advisors should carefully examine each bond’s characteristics to determine if a higher yield is worth the extra risk. Investors willing to accept higher risk may benefit from potentially higher returns.
FlexibilityThere are three general maturity categories for corporate bonds: 1. Short-term – up to five years; 2. Medium-term – five to 12 years; and 3. Long-term – greater than 12 years. Although longer maturity bonds may offer higher rates, their prices tend to be more sensitive to changes in interest rates. Investors with short investment horizons should not buy long-term bonds, as proceeds from sale prior to maturity may be less than the original investment.
Like many other fixed income investments, corporate bonds offer various coupon structures:
Fixed coupon rate is set at the time of issuance and does not change until the bond has matured. The interest payments are predictable and, usually, paid semi-annually or monthly.
Zero coupon rate bonds do not pay any interest during their lifetimes and are issued at a discount from par value. However, income is taxed annually although not received by the investor until maturity. These securities may be suitable for investors who are trying to meet future financial obligations, such as college tuition, because at maturity the issuer will repay the full face value. Since no interest is paid, investors are usually compensated with a higher yield.
Floating coupon rate is tied to a reference benchmark, such as short-term Treasury bills, LIBOR or CPI indices, and changes as the corresponding index is reset. The interest rate is quoted as a certain number of basis points over the index – known as the spread. For example: LIBOR + 250 basis points. Spread is determined at the time of issuance and remains fixed until maturity. As the index adjusts, so do the interest payments – this may happen monthly, quarterly, semi-annually or annually.
Step coupon rate changes at predetermined intervals and usually increases (steps up) in equal increments. The step rate schedule is established at the time of issuance. These securities are generally issued with a call feature. The initial interest rate is paid until the first call date and, if not called, steps to the next level. Step-up bonds may offer lower initial interest rates than comparable fixed rate securities; however, if not called, they will keep stepping up and may result in a higher total return. This can be a defensive strategy if investors anticipate an increase in market interest rates.
Investors can match payment frequencies with the need for cash flow as corporate bonds offer interest payments on monthly, quarterly or semi-annual basis. Credit ratings, which define an issuer’s creditworthiness, also vary by company. More on credit ratings is provided below.
Survivor’s Option Some corporate bonds offer an estate protection feature, which allows an estate, upon evidence of death of the bondholder, to redeem bonds from the issuer at par plus any accrued interest. This feature may be subject to minimum holding periods, individual limits, issuer limits and other rules that vary by issuer. Terms and conditions are fully described in the prospectus, offering circular or disclosure document. You should not rely on this feature for immediate liquidity.
Liquidity Although not obligated to do so, many broker/dealers participate in the secondary market for corporate bonds. Investors who need access to cash may sell their bonds prior to maturity, at current market prices. In the secondary market, trading timeliness and prices are subject to market interest rates, issue and position size, credit rating, and other factors. Some bonds trade more often than others and may be easier to sell. The proceeds from sale may be more or less than the original investment. However, if bonds are held until the final maturity date, the investor will receive the full face value, subject to credit risk.
In order to improve market transparency, the Financial Industry Regulatory Authority (FINRA) created TRACE – Trade Reporting and Compliance Engine. Investors can access historical data on market transactions for publicly traded securities, including corporate bonds, at investinginbonds.com.
Interest Rate Risk Bond prices rise and fall in response to interest rate changes. When interest rates rise, future interest payments of previously issued bonds become less attractive, so investors are willing to pay less for these bonds in the secondary market. Conversely, when interest rates fall, investor demand for higher interest payments drives bond prices up.
An increase in interest rates will have a larger impact on the principal value of longer-maturity bonds than on those with shorter maturities. However, if the securities are callable, a decrease in interest rates will not have as much impact on bond values, given that issuers are more likely to call bonds at par in a decreasing interest rate environment.
Market Risk If bonds are sold prior to maturity, an investor will receive the then current market price which may be more or less than the original cost. At the time of sale, a bond’s price will depend on market interest rates, order size, issuer’s credit rating, and the level of demand for that particular issue, among other factors.
Reinvestment Risk Some corporate bonds are issued with a call feature, which allows an issuer, at its option, to pay back the principal before the stated maturity date. Several call options exist depending on specific stipulations set in the prospectus. The most common call options are: American call – bonds become callable at par anytime after the original non-call period; Bermuda call – bonds are callable at par on interest payment date after the original non-call period; and Make Whole call – bonds are callable at a spread to a comparable Treasury security. Call schedules are determined at the time of issuance and vary by offering. Generally, an issuer is more likely to call bonds when interest rates decline so it can offer new bonds with lower coupon rates. If called, the bonds will stop paying interest. In this case, investors may be forced to accept lower interest payments as they reinvest the returned principal at lower rates. To learn about different types of call options, visit raymondjames.com and read the Callable Bonds fact sheet.
Returns Corporate bonds may trade at par (usually $1,000 per bond) or a market premium or discount from par. Bond yields should be evaluated on a worst-case-scenario basis. The two yields are:
Yield-To-Maturity (YTM) is especially important when bonds are purchased at a discount. Investors should compare YTM to the current yield of comparable new issue bonds to make sure that the discount is big enough to result in the same return or higher. YTM for a new issue security is equal to its coupon rate.
Yield-To-Call (YTC or yield-to-worst case YWC) must be considered when a bond has call features and is purchased at a premium. An issuer is more likely to call the security prior to maturity when market interest rates decline, giving the company an opportunity to offer new bonds at lower rates. The prices of callable bonds will not rise as much as those of non-callable securities because investors are not willing to pay more due to the increased chance of a call.
Credit Ratings Corporate bonds are rated by independent rating agencies, such as Moody’s Investors Service, Standard and Poor’s Financial Services, LLC and/or Fitch Ratings Ltd. Ratings are appraisals of the issuer’s ability to pay interest and principal and are not recommendations to buy, sell or hold. Credit ratings are subject to reviews, changes or withdrawal at any time.
Bonds carrying a credit rating of Baa3/BBB- or higher are considered investment grade. Most offerings are unsecured debt and backed only by the issuer’s promise to pay. Therefore, a bond’s value may decrease if the issuer’s credit rating deteriorates and the possibility of default increases. Bonds with a credit rating below Baa3/BBB- are called “junk bonds” and should only be purchased by investors with a high tolerance for risk as there may be a possibility of significant price volatility and a potential loss of the entire investment. More information about credit ratings is available at moodys.com, standardandpoors.com and fitchratings.com.
|INVESTMENT GRADE||NON-INVESTMENT GRADE|
|Standard & Poor's||AAA||AA||A||BBB||BB||B||CCC||CC||C||D|
It is important to note that, in some situations, the credit rating may not fully represent an issuer’s true creditworthiness. Investors’ perception of a company’s financial health may greatly affect the market value of its bonds without an official change in credit rating. Bonds should be compared on a yield basis, as it is a reflection of risk. If an investment-grade bond is trading at a yield usually seen on a “junk bond,” then the amount of risk associated with this bond and its issuer is perceived to be much higher than what is shown by the credit rating. In other words, in some instances, “Yield speaks louder than ratings.”
Priority of Claim Should the bond issuer become insolvent, the company’s assets may be liquidated to compensate the creditors, including the bondholders. Corporate bonds provide investors with a higher priority of claim on the assets of the issuer than the holders of preferred securities or common stock.
|PRIORITY OF CLAIMS|
|Senior Secured Debt Holders|
|Senior Unsecured Debt Holders|
|Subordinated Debt Holders|
Taxation Interest income from corporate bonds is generally subject to federal, state and/or local taxes. Investors who decide to sell bonds before the final maturity date may incur capital gains or losses and are advised to consult a tax advisor to ensure proper tax reporting.
Issuance Form Corporate bonds purchased through Raymond James are generally issued in book-entry form. This means that no physical certificates are issued to clients. Most corporate bonds have one master certificate, which is kept at a securities depository. An investor’s interest ownership in the certificate is recorded in his or her brokerage account.
Commission and other Fees Bonds are traded on either a principal or agency basis. A trade done directly with an investor’s own firm is considered a principal trade and a markup/markdown may be included in a bond’s price. If using the firm as an agent to facilitate a trade with a different firm, an investor may pay a commission or a fee in addition to a bond’s price. Commission rates and markups vary among offerings and depend on the type of bond, the time remaining until maturity and size of the trade.
Diversification is a time-tested strategy to help stabilize portfolio returns and meet specific investment objectives. However, diversification does not ensure a profit or protect against a loss. Corporate bonds come in a wide range of maturities, payment frequencies, coupon structures, credit ratings and other features, such as calls and survivor’s option. Bonds are issued by companies in many industries – from finance to healthcare to transportation. Choosing investments from different industries and issuers is important as they may behave differently in changing economic and market environments. Bond investors should monitor rating agency updates as well as company and industry news, and adjust their portfolios accordingly.
Corporate bonds are most suitable for investors who are interested in a fixed rate of return and relative safety of principal, subject to the credit wort hiness of the issuer. Various bond structures are available in the market and not all offerings may be suitable for every investor. To learn more about risks and benefits of corporate bonds and how you can utilize them to enhance your portfolio’s performance, speak with your Raymond James financial advisor and visit http://www.raymondjames.com/wealth-management/fixed-income, the Securities Industry and Financial Markets Association's http://www.investinginbonds.com/ and/or FINRA’s site http://www.finra.org/.
Investing involves risk and you may incur a profit or a loss. The value of fixed income securities fluctuates and investors may receive more or less than their original investments if sold prior to maturity. Bonds are subject to price change and availability. Investments in debt securities involve a variety of risks, including credit risk, interest rate risk, and liquidity risk. Investments in debt securities rated below investment grade (commonly referred to as “junk bonds”) may be subject to greater levels of credit and liquidity risk than investments in investment grade securities. Investors who own fixed income securities should be aware of the relationship between interest rates and the price of those securities. As a general rule, the price of a bond moves inversely to changes in interest rates. Diversification does not ensure a profit or protect against a loss.
The information contained herein has been prepared from sources believed reliable but is not guaranteed by Raymond James & Associates, Inc. (RJA) and is not a complete summary or statement of all available data, nor is it to be construed as an offer to buy or sell any securities referred to herein. Trading ideas expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation or needs of individual investors. Investors are urged to obtain and review the relevant documents in their entirety. RJA is providing this communication on the condition that it will not form the primary basis for any investment decision you may make. Furthermore, because these are only trade ideas, investors should assume that RJA will not produce any follow-up. Employees of RJA or its affiliates may, at times, release written or oral commentary, technical analysis or trading strategies that differ from the opinions expressed within. RJA and/or its employees involved in the preparation or the issuance of this communication may have positions in the securities discussed herein. Securities identified herein are subject to availability and changes in price. All prices and/or yields are indications for informational purposes only. Additional information is available upon request.