Corporate bonds are called fixed-income investments because they provide periodic interest payments at a fixed rate. Corporate bonds are considered the riskiest of fixed-income investments. The risks associated with investing in corporate bonds place an importance on investors performing corporate bond analysis. Understanding the elements of corporate bonds and the associated risks can help investors choose bonds that provide the best opportunity to earn a profit at the investor’s risk level.
Reviewing a company’s corporate bond credit rating is an essential element of corporate bond analysis. The credit rating assigned to a corporate bond is an indicator of the company’s creditworthiness. Credit ratings are important because they affect a bond’s yield. Corporate bonds with low credit ratings are often called high-yield bonds because the company must offer high interest rates to entice investors to assume the associated risks. Investors who are risk-averse typically look for corporate bonds with high credit ratings and a company with a stable financial history, although the bonds may offer lower yields than high-yield bonds.
Interest Rate Risk
Another factor to consider when analyzing corporate bonds is interest rate risk, which involves the risk that changes in the market interest rate will cause the face value of corporate bonds to decline. An increase in interest rates causes a decline in bond value, and a decline in interest rates causes bond prices to rise. Interest rate risk is important in corporate bond analysis because it determines if bonds are bought or sold at a premium or discount. For example, you bought a 20-year bond at 6 percent interest one year ago and interest rates are currently at 8 percent. If for some reason you need to sell your bond today, you must offer it at a discount because investors will not pay full price for a bond offering a lower interest rate than the current market rate.
Another element within corporate bond analysis is the coupon rate, which involves the fixed rate the company pays investors until the bond’s maturity date. The coupon rate should reflect the default risk and maturity date associated with the bond. Companies should compensate investors for placing their money in an organization that is not financially strong or proven. Corporate bonds with long maturity dates should offer higher coupon rates to compensate investors for allowing the company to borrow money for a long period of time.
Investors should understand the call risk associated with a corporate bond before investing money. Call risk involves the possibility that the issuer calls back the bond before the maturity date. When a bond is called back, the investor receives the principal but no longer receives interest payments. The issue with callable bonds is that the bond issuer usually calls back the bond when interest rates decline. This benefits the corporation because it can reissue the bond at a lower interest rate. The investor is at a disadvantage because he will experience a difficult time finding a bond paying a similar interest rate than the one the corporation called back. Not all bonds are callable, so investors should analyze a company’s terms regarding its corporate bonds.
- American Association of Individual Investors: Corporate Bond Analysis: What to Consider
- CBS News: What to Consider Before Investing in Corporate Bonds
- New York Stock Exchange: Understanding Credit Ratings
- FINRA Investors: Interest Rate Risk
- Money-Zine: Understanding Bond Yields
- FINRA Investors: Call Risk
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