Investing in bonds has always carried an air of mystique. The terminology surrounding the assessment of credit risk, the calculation of yield and the classification of the security is often enough to discourage the average investor from wading into this investment opportunity.
Investment in corporate bonds, however, whether investment grade or high yield, offers an opportunity in the current market environment for an investor to earn current income and future price appreciation.
What is a Corporate Bond?
In the most fundamental sense, a corporate bond is nothing more than making a loan to a company.
Corporations need to raise capital for a variety of reasons, including growth, funding a leveraged buy-out and providing cash for operating expenses.
Capital can be raised by offering ownership opportunity to the investor (the sale of company stock), by issuing corporate bonds or convertible bonds or by securing bank loans.
An investor purchasing a corporate bond has leant money to the company just as a bank might.
The corporate bond market has become the largest of the three primary bond markets. With over $5 trillion in outstanding bonds, as of 2006, the corporate bond market exceeded the US Treasury market, with $4 trillion outstanding and the municipal market which stood at $1 trillion.
About 80% of currently outstanding corporate bonds are of investment grade quality with ratings of BBB- or better by Standards and Poor’s, Baa2 or better by Moody’s and BBB- by Fitch. The remaining 20% constitute the “high yield” or “junk” bond market.
About 20% of the outstanding corporate debt is considered to be in the high yield category. This is a substantial increase from 1992, when there was about $200 billion of high yield bonds held by investors.
Who Buys Corporate Bonds?
The vast majority, well over 90%, of corporate bonds are purchased at the time of initial offering by mutual funds, insurance companies and other institutional investors.
While individuals are typically not buyers in the initial offering…
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…they do make up over 65% of the trading in the corporate bond secondary market. A significant opportunity exists for the individual investor to gain current income and future capital gains through the purchase of corporate bonds in the secondary market.
Benefits to the Individual Investor
Benefits to the individual investor in corporate bonds, in addition to an ongoing income stream, include higher yields, a diverse range of industries, a choice of maturities and a priority claim ahead of stock holders in the event of a bankruptcy by the company issuing the bonds.
In some cases, the investor may also have a priority claim as to the proceeds derived from the sale of a specific asset of the bankrupt company.
Bonds in this latter group are labeled as senior lien bonds or collateralized bonds. Bonds not collateralized may be classified as subordinate bonds. Subordinate bonds still come before shareholders in a liquidation, but stand behind more senior debt obligations of the company.
How Do Corporate Bonds Appreciate in Value?
There are two primary ways for a corporate bond to produce a capital gains opportunity for the investor.
The credit quality of a company’s debt can improve as a result of a strengthened balance sheet; a merger with a stronger company or from improvement in the company’s operating performance.
Generally these positive changes would be reflected in a credit ratings upgrade by one or more of the rating agencies. The changes could also result from improvement in the market perception of the company’s ability to pay.
The second way for corporate bonds to appreciate results from changing credit market conditions. Corporate bonds trade at yields expressed as a spread to US Treasury securities. In normal conditions, corporate bonds will trade at yields of 100 to 200 basis points higher than comparable treasuries.
Currently, corporate bonds are trading at yields reflecting a default rate of over 20%, producing yields for investment grade bonds more than 500 basis points higher than treasuries. Much of this premium is attributable to the collapse of the credit markets which dominated the news in the last half of 2008.
As credit becomes more available, the spread premium required to market corporates will decrease. Yield requirements for these bonds will drop at a rate steeper than the increase in treasury yields as investors move to purchase investment grade and high yield corporate bonds.
The drop in corporate yields will produce an increase in value, generating capital appreciation for the investor. The investor will have enjoyed cash flow while holding the bond and a capital gain if sold before maturity.
This article was written by Jamie Dlugosch, contributor to InvestorPlace.com. For more actionable insight like this, go to: www.InvestorPlace.com. James F. Dlugosch contributed to this article.
