Corporate bonds can often outperform stocks but have less investment risk. Corporate bond issuers have obligations to pay interest and return an investor's principal at maturity, a much more stringent requirement than stock issuers, which can suspend dividends at any time and have no obligations to repay stock investments. These bond issuer obligations help bonds retain their value even during challenging times. Corporate bonds can fit many risk/reward profiles and are a much-needed complement to stocks in investor portfolios.
|Strong potential returns with lower risk
|Greater certainty of recurring income
|Greater protection of principal
|More investment options
A key advantage of individual corporate bonds vs. stocks is that they can achieve strong investment returns and limit your downside. While corporate bonds typically do not experience the price volatility of stocks, a variety of factors can cause corporate bond prices to move, which can create opportunities to invest in corporate bonds with strong upside.
Being able to quantify your downside is an important tool for individual bond investors. A key reason why there is less downside to bonds vs. stocks is that a bond is a contract between the issuing company and the bondholder. The company must pay interest on the bonds on specific dates, and it must return the face value of the bond ($1,000 per bond) at the bond's maturity date. Both of these factors stabilize the value of corporate bonds. Stocks don't provide the same level of commitment to shareholders, as a company can suspend dividend payments, and investors have limited recourse other than selling the stock. We saw this during the COVID-19 crisis, as some of the largest companies in the world, including Disney, Royal Dutch Shell, Boeing, and Ford either suspended or reduced their stock dividends.
In addition to having contracted interest and principal payments, corporate bondholders are senior to common and preferred stockholders in a company's capital structure. This is most relevant in the event a company files for Chapter 11. In such cases, bondholders often will not be made whole; however, since they are senior to stockholders, bondholders are guaranteed to have a larger recovery of their principal than stockholders, who are often completely wiped out.
Bond issuers have contractual obligations to bondholders that are much more stringent than obligations to shareholders. This starts with the bond issuer's obligation to pay interest on time, typically on a semi-annual basis. If a company stops paying its interest to bondholders, the issuer could be deemed to have caused an 'event of default,' which could enable bondholders to take certain actions to obtain their interest payments and/or a return of their principal. Stocks do not have these same obligations, and companies can, at the drop of a hat, suspend dividend payments to stockholders, as happened during the COVID-19 crisis in 2020.
Many retirement investors need to know that recurring interest or dividend payments will continue to be paid, which is why corporate bonds can be a more compelling investment opportunity for retirement investors seeking a reliable income stream. It wasn't too long ago that General Electric had a AAA credit rating and was one of the world's most valuable companies. After years of underperformance, in October 2018, GE cut its quarterly dividend to $0.01 per share. If this can occur at one of the world's most valuable companies, no stockholder is immune from dividend cuts or suspensions.
When investors buy stock of a company, there is no guarantee that the company will repay the investor anything. The stock could go up and it could go down depending on the company's performance and market conditions.
As noted above, the face value of a corporate bond is $1,000. When a bond matures, the issuing company owes the bondholder the face value of the bond he purchased. This provides corporate bond investors with a much higher level of principal security relative to stockholders.
In addition, bondholders are more senior in a company's capital structure than stockholders. In the event of a bankruptcy, stockholders typically get wiped out where bondholders can recover a portion of their principal depending on the value of the company and what other debt obligations it has.
Being senior in a company's capital structure and having a contractual obligation to receive the bond's face value at maturity provides corporate bondholders a greater level of principal protection than that of stockholders.
On any given day, people can invest in nearly 9,000 individual corporate bonds, approximately double the number of publicly traded stocks. This enables investors to build portfolios that are well suited to their investment objectives and risk profiles. For example, a more aggressive investor could favor high-yield bonds and longer-dated investment grade bonds. More conservative investors may stick to bonds of higher credit quality and, to reduce pricing volatility, limit the time to maturity of investment-grade bonds. We like to say "there's a corporate bond for everyone."
We expect this enhanced level of investment choice in bonds vs. stocks to continue, as corporate bond issuance has remained strong and the number of companies going public through initial public offerings (IPOs) has waned, falling 67% from 1999 to 2017. The number of publicly traded stocks decreased 45% from 1996 to 2015.
While 2018 corporate bond issuance fell to $1.3 trillion vs. $1.6 trillion in 2017, the previous-record 2017 issuance levels were a 3.5x increase from 1997. In Q4 2018, companies sold over six times more in bonds vs. stocks. At the end of 2018, there was approximately $9.2 trillion of corporate bonds outstanding, which is 2.4x the size of the municipal bond market and nearly 60% the size of the United States Treasury market.
In the wake of COVID-19 in 2020, many companies needed to borrow heavily to finance losses as a result of many industries being shut down or significantly restricted. As shown in Figure 1, monthly corporate bond issuance surged to record levels in April and May 2020. Monthly investment-grade corporate bond issuance exceeded $250 billion in both April and May 2020. Across these two months alone, companies issued over $500 billion in corporate bonds, which was over 40% of all 2018 investment-grade corporate bond issuance.
While many companies have work to do to support their new levels of indebtedness, the significant issuance shows a robust corporate bond market that can serve investors across varying investment objectives and risk profiles.
This article reviews our rationale for owning corporate bonds vs. stocks. For a perspective on dividend stocks, you may find the following websites of interest:
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