Beginning investors tend to focus on successful companies to make profits. As they progress, though, they may investigate how to buy corporate debt to diversify their portfolios.
It may sound counterintuitive that one can profit from company debt. Indeed, it’s an investing strategy that’s better suited to investors with higher risk tolerance. For such investors, corporate bonds could offer consistent, predictable revenue streams while diversifying their portfolios.
In this post, Gorilla Trades takes a closer look at how to buy corporate debt, the types of corporate bonds available, and strategies for limiting risk and maintaining fixed income investments.
What Is Corporate Debt?
Businesses need funding from time to time to improve operations, stimulate growth, take on new projects, and carry out other priorities. Part of that funding comes from revenue and company stockholders, as well as issuing more shares.
However, by borrowing funds through corporate debt, companies can amass great amounts of capital without issuing more shares, which would devalue shareholders’ ownership. Companies also stand to gain tax advantages from borrowing through debt, as interest payments are generally tax-deductible.
To use debt, companies take out bonds and other time-limited instruments. They promise to repay the investors, with interest, over a given time. Investors stand to earn consistent interest payments throughout the term of the loan. When the bond reaches maturity, investors get their initial principal back to go along with the interest they’ve earned.
Corporate debt is a fixed income investment, which means it provides predictable interest payments on a regular basis. Investors don’t receive stock shares or equity in the company — instead, they’re essentially creditors that the company must eventually pay back.
Bond Ratings and Risk Assessment
Bond credit ratings play a big part in corporate debt. These are comparable to credit ratings, only for companies rather than individuals. Credit rating agencies like Moody’s, S&P, and Fitch issue bond ratings to represent the companies’ likelihood to repay debts.
Higher-rated bonds are considered safer and likely to be paid off more easily. Bonds with high credit ratings are referred to as “investment-grade bonds.” Companies with lower ratings are seen as carrying more credit risk.
Corporate bonds are different from government and municipal bonds because private companies underwrite them. Government and municipal bonds are backed by federal entities and local governmental bodies. They may be safer than corporate bonds, but they generate lower or more inconsistent income.
Types of Corporate Bonds
Corporate bonds are differentiated by their structure, their risk level, and the range of returns they may offer. Along with investment-grade bonds, other bond types are defined as follows.
Junk Bonds
More properly known as high-yield bonds, junk bonds are issued by companies with low credit ratings (generally BBB-minus and lower). They’re basically the opposite of investment-grade bonds. While they could result in higher yields, junk bonds are extremely risky and likelier to default.
Convertible Bonds
Convertible bonds allow investors to transform their bonds into company shares. If the company’s stock price goes up, convertible bonds give investors an opportunity to realize higher capital gains. Convertible bonds usually have lower interest rates because of the prospect of added value from the conversion.
Callable Bonds
When a company issues a callable bond, it reserves the option of redeeming (“calling”) it before it matures. Usually, this is because the company needs to access capital quickly or refinance its debt at lower interest rates. When the bond is called, investors get the face value of the premium back, and interest payments stop.
Zero-Coupon Bonds
Zero-coupon bonds are issued for significantly less than their face value. There are no interest payments with zero-coupon bonds, but when they mature, investors get the full face value of the premium back.
Perpetual Bonds
Perpetual bonds have no maturity date. Instead, investors receive regular interest payments indefinitely as long as the bond exists.
After investment-grade bonds, these are the most common or popular corporate bonds. There are other types an issuer may consider. Ask your brokerage what kinds of corporate debt plans you may access.
Risks of Buying Corporate Debt
Every financial instrument comes with at least some risk. This is especially true with corporate debts, which may entail these risks. Before you buy corporate debt, consider some of these potential drawbacks.
Default Risk
Every loan runs a certain level of default risk. Since they’re backed by companies and are not guaranteed by federal agencies, corporate bonds are considered more likely to default. Lower-grade bonds, like those considered junk bonds, are especially susceptible to default.
Interest Rate Changes
A basic rule of thumb in investing is that when interest rates go up, low-yield bonds tend to decline in value. When rates are lowered, the bond value increases. This is especially true of long-term corporate bonds, which could be subject to wild fluctuations.
Credit Risk
When the bond rating agencies downgrade certain bonds, they run the risk of waning market prices and may struggle to maintain payments. This makes investors jittery about the bond.
Call Risk
If the issuing company calls a bond before maturity, especially if interest rates go down, investors may scramble to reallocate their funding capital. This may strike a blow to their profits.
Vehicles of Corporate Debt
Many financial instruments already familiar to investors can be deployed to structure corporate debt. These include purchasing the bond directly from the issuer, bond funds, exchange-traded funds (ETFs), and other means. This makes the process easier and more accessible, especially for new investors.
Corporate bonds may also be obtained from secondary markets, like exchanges or over-the-counter (OTC) trades. Bonds on secondary markets tend to be more liquid and adaptable, so investors may be able to cash in before the bonds mature.
Strategies for Buying Corporate Debt
There are a few novel bond market strategies investors may consider when they are ready to buy corporate debt.
Laddering
The laddering strategy simply means the investor buys multiple bonds with staggered dates of maturity. This gives the investor direct access to the capital during the lives of their bonds. Laddering also mutes much of the risk from interest rate changes, and it is especially effective in balancing short-term bonds with long-term, moderate-yield bonds.
Barbell Investing
In this strategy, the investor buys multiple long- and short-term bonds at the same time. This lets the investor balance yields from short-term bonds with the steadier, potentially higher yields from long-term holdings. Intermediate-term bonds are generally excluded from the barbell investing strategy.
Diversification
A basic plank of just about every investment plan, diversification means allocating capital funds across several different financial traits — mixing business sectors, market cap, high and low yields, and other criteria.
Diversification is a way for investors to mitigate the risk of losses in one sector with gains from another sector that is performing well. Corporate bonds benefit from diversification just as securities and mutual funds do.
Ready to Buy Corporate Debt?
Corporate bonds give investors another unique vehicle for managing and growing wealth. For those willing to shoulder more risk to generate more predictable income, the various kinds of corporate bond structures may prove worthy additions to your portfolio strategy.
With due research, review, and consultation, you may be able to move forward with a solid strategy for investing in corporate bonds. After evaluating the risks of corporate debt and the many ways you can execute corporate bonds, you may very well be ready to reap the rewards.
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