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We founded BondSavvy in 2017 so more individual investors could benefit from the income, capital growth, and relative safety individual corporate bonds can provide. Few investors take advantage of owning corporate bonds and, instead, favor bond funds, stocks, and even -- yikes -- cryptocurrency. We believe the advantages of corporate bonds are too important for investors to overlook; however, it's important investors also understand corporate bonds disadvantages.
Corporate Bond Advantages and Disadvantages
This bond investing FAQ article is not a sales pitch. We first discuss the advantages corporate bonds have vs. bond funds, municipal bonds, and stocks. After reviewing corporate bonds advantages, we then discuss corporate bonds disadvantages. Not all of the disadvantages apply to the other asset classes, which is why we discuss corporate bonds advantages and disadvantages separately.
Based on the information we present, readers can decide whether owning individual corporate bonds makes sense for them.
Corporate Bonds Advantages
The best way to evaluate corporate bond advantages and disadvantages is to compare corporate bonds to other asset classes across key investment considerations. In Figure 1, we compare individual corporate bonds to bond funds, municipal bonds, and stocks.
We evaluate each asset class across five criteria:
- Security of principal
- Security of income
- Higher potential investment returns
- Quality financial disclosures
- Pricing transparency
A 'thumbs up' in Figure 1 means an asset class compares favorably to the others, while a sad face indicates the opposite. For example, security of principal and income are strong across corporate bonds, bond funds, and municipal bonds but less so for stocks.
Individual corporate bonds are the only asset class to receive a thumbs up across all five criteria, as shown in Figure 1.
Figure 1: Corporate Bonds Advantages vs. Other Asset Classes
Corporate bonds advantages: Security of income
Many investors compare dividend yields to bond yields and believe they are the same thing, but they are not. Company dividends can be reduced or eliminated at a moment's notice. This happened in the wake of Covid-19, as many blue-chip companies either stopped paying dividends or significantly reduced them.
These companies included some of the largest companies in the world such as Boeing, Disney, Royal Dutch Shell, and GM. During these difficult Covid times, all of these companies continued making their bond coupon payments.
Yes, there can be cases when a corporate bond issuer defaults; however, these defaults generally occur in higher-risk issuers -- not Boeing and Royal Dutch Shell.
Security of income across fixed income investments
While fixed income investments provide higher income security than stocks, there are some differences across corporate bonds, municipal bonds, and bond funds.
The security Investors owning individual corporate bonds and municipal bonds will depend, in large part, on the creditworthiness of the bond issuer and the number of bonds held in an investor's portfolio. As you might expect, a 10-bond portfolio filled mostly with high-yield corporate bonds would have a lower level of income security than a 30-bond portfolio containing bonds of higher credit quality.
Given they can own thousands of bonds, certain bond funds and ETFs can have a higher level of income security than a smaller portfolio of individual bonds.
Corporate bonds advantages: Security of principal
Corporate bond issuers have an obligation to pay bondholders the par value of a bond on a bond's maturity date. Yes, bond prices can still go down (as many have in 2022); however, this obligation provides principal protection not offered by stocks.
For investors in corporate bonds, muni bonds, and bond funds, it's important for investors not to believe 'security of principal' implies a lack of potential volatility. As we have seen in 2022, certain bonds such as Apple 2.55% 8/20/60 (CUSIP 037833EA4) and Wal-Mart 2.65% 9/22/51 (CUSIP 931142EV1) had fallen over 40 points when they reached all-time lows on October 24, 2022.
Such paper losses can occur in corporate bonds; however, the threat of permanent capital loss is still generally low. [As with income security ................................
Disadvantages of Corporate Bonds
While corporate bonds advantages are significant, new corporate bond investors must go in with their eyes open and be aware of the risks and disadvantages.
Some corporate bonds have limited trading activity
Corporate bond investing has come a long way from the 1970s and 1980s, when most bond trades were done over the phone, and investors had little idea on whether they were getting a fair price. In our Where to Buy Bonds article, we discuss how corporate bond trading for individual investors is primarily conducted online in a competitive and [__________] environment.
While corporate bonds trade online through brokerages such as Fidelity.com, Schwab, E*TRADE, and Schwab, there can be times when trading activity -- and the amount of live bid-offer quotes -- can be limited. A key reason for this is that, on any given trading day, there are approximately 9,000 individual corporate bonds available on online brokerages. Since trading activity can be spread across such a large number of bonds, there can be bonds that don't trade every day.
When BondSavvy makes new corporate bond investment recommendations, we evaluate a bond's trading activity and amount of live bid-offer quotes (the "depth of book") to ensure the market can accommodate the new order flow our bond recommendations create.
Corporate bonds can be volatile
Many people hear the word "bonds" and automatically think they are investing in something that is super-safe. While corporate bonds must return to their par value on their maturity date (assuming no issuer default), for certain bonds, it can be a rollercoaster ride.
The Federal Reserve's unprecedented interest rate hikes in 2022 have shown investors how bond prices can fall in an extreme scenario.
Some corporate bonds can be highly sensitive to movements in US Treasury Yields
As we discuss in our corporate bond credit spreads blog post, corporate bond prices movements can be driven by a variety of factors. BondSavvy seeks to identify bonds issued by companies with strong financials that have compelling yields and prices relative to their risk.
Investment grade corporate bonds can be highly sensitive to movements in US Treasury YTMs. Often times, bond investors can invest in a bond issued by a great company with strong financials only to have a bond's price fall due to rising US Treasury yields.
Of course, the opposite can happen, as, when US Treasury yields fall, investment grade corporate bonds can have a significant tailwind.
[Show long term corporate bond price charts]
Corporate bonds can be heavily impacted by bond ratings upgrades and downgrades
While there are many advantages to owning individual bonds vs. bond funds, the vast majority of corporate bonds are still held by institutional investors such as bond mutual funds, bond ETFs, insurance companies, and pension plans. Bonds held by these entities are often determined by bond ratings, as many of these investment vehicles have restrictions on owning bonds below a specific corporate bond rating.
When corporate bond ratings are downgraded from investment grade (Baa3 / BBB- and higher) to below investment grade, forced selling can occur as certain institutional funds have to sell the downgraded bonds. It is a smaller group of investors that can own high yield corporate bonds, so these price drops can often be significant.
That said, these "fallen angels" bonds can often be compelling investment opportunities, as many high yield corporate bonds can have stronger financials than many bonds with higher bond ratings due to the many flaws of corporate bond ratings.
Corporate bonds aren't always a bond issuer's most senior debt
While corporate bonds are senior to common and preferred stock issued by a company, there can be debt that is senior to a company's unsecured bonds. This can be a big issue in the event a company files for Chapter 11 and the company cannot satisfy all of its obligations. This happened when JC Penney filed for Chapter 11 in 2020. It had a significant level of bank debt that was senior to the company's unsecured bonds. When the company emerged from Chapter 11, the senior debt had nearly full recoveries but the company's unsecured bonds were mostly wiped out.
In each new BondSavvy corporate bond recommendation, we review a company's capital structure to determine whether any debt is senior to our recommended bonds. Unfortunately, this analysis is not always fool-proof, as, after a new recommendation, a company can incur debt that is senior to our bonds.
In such a scenario, our bonds can be downgraded by the rating agencies given their newly found junior position in the company's capital structure. Such downgrades can cause bond prices to fall. If a company has a strong business and is operating well, senior debt is
Corporate bond prices have ceilings
Since bonds contractually pay bondholders the par value of a bond at maturity, their upside is limited. While corporate bonds can increase significantly in value, it's rare for bond prices to reach 150% of their par value. This is very different than a stock, which can increase with no upward bound.
In addition to bonds paying their par value at maturity, many corporate bonds (in particular, high yield corporate bonds) can be redeemed ("called") by the issuer prior to maturity. These call prices are generally between 101.50 and 107.50. Since high yield corporate bonds are typically subject to call schedules, their pricing upside is often less than that of investment grade corporate bonds, which are generally subject to bondholder-friendly "make-whole-call" provisions that are seldom invoked prior to maturity.
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Stock buyback binges can advantage stockholders over bondholders
Perhaps one of the most difficult things to come to grips with as a bondholder is the seemingly never-ending fascination of companies with stock buybacks. While bonds are supposed to be senior to common stockholders, these massive buybacks often seem as though the opposite is true.
Stock buybacks can create a floor under a stock price and can, at least over the short term, create a bounce in a stock price. This can be a good thing for short-term stockholders (like so-called 'activist' investors) and executives looking to execute stock option grants.
Unfortunately, these buybacks s can often put companies into a pickle in the event a business underperforms. The poster child for ill-fated company stock buyback binges is Bed Bath & Beyond, which bought back $12 billion in stock between 2004 and 2022. When Bed Bath ran into operational performance issues in 2022, it had to hurry to raise senior bank debt to fund operations.
Bed Bath now has debt that is senior to its unsecured bonds, which, along with the company's week recent financial performance, caused certain company bonds to fall as low as 10% of their face value. The company, in October 2022, began effecting exchange offers for its bonds.......
Had Bed Bath not backed up to the truck to its buyback machine, it could have
Wrap up
There are many advantages of corporate bonds relative to other investments. Individual corporate bonds offer investors strong returns but with less downside than stocks. They offer greater transparency than bond
funds and ETFs, as you know precisely the security in which you are investing and can invest according to your risk tolerance and investment returns
objectives. If you own an individual corporate bond, you pay a fee when you buy it and if you sell the bond prior to maturity. This fee
structure can offer considerable savings to the recurring fees investors pay when investing in bond funds and bond ETFs.
We believe there is far greater financial reporting transparency for corporate bonds compared to municipal bonds, as corporate bond issuers are required
to report their financial performance quarterly and have other reporting requirements when material events occur at the company. Municipal bond
issuers have far less stringent financial reporting requirements. Taken together, we believe investors can better assess the value of a corporate
bond than a municipal bond since there is a far greater level of financial information available to corporate bond investors. This presents opportunities
for corporate bond investors to achieve strong capital appreciation, and, as a result, after-tax returns that can exceed those of municipal bonds.
Please click here for a detailed comparison of the advantages of individual corporate bonds vs. municipal bonds.
