If you would like to diversify your portfolio by buying corporate bonds but aren’t sure about the investment strategy involved, review the following important points:
What is a Corporate Bond?
Corporate bonds are debt securities issued by corporations in order to raise money and expand business. The bond is basically an IOU from the corporation to investors and they are responsible for paying the loan back, including interest, by the maturity date. Essentially, the corporation is borrowing from corporate bond buyers and rewarding them for their risky investment with a high return.
The Risk of Corporate Bonds
The higher corporate bond rate of interest is the reason why some people choose to invest in corporate bonds instead of other interest-bearing securities like money market accounts or CDs. However, with greater return comes greater risk. There is always a chance that a corporation could default and you could lose your money. Therefore, the riskier a bond is, the higher the chance of default but also the corresponding interest rate.
All corporate bonds come with a risk of default, even if that chance is tiny. Third-party rating systems exist to determine the financial soundness of a company and the level of risk they present to investors.
Choosing a Corporate Bond According to Ratings
If you want to invest in a corporate bond, check how the financial stability of a corporation is rated by an organization such as Standard & Poor’s or Moody’s. All rating organizations use different criteria that can be somewhat complicated, so be sure you understand what a rating means before making any decisions.
Highly rated bonds (referred to as investment-grade) are less risky while poorly rated corporate bonds (known as “junk bonds”) are most likely to default but also have a higher interest rate and yield.
How to Invest in Corporate Bonds
Consider whether you’re looking for a safe and reliable investment or a high-risk, high-yield corporate bond. Depending upon your portfolio strategy, either can be a beneficial investment.
If you’re uncomfortable with the risk associated with corporate bonds but are enticed by the interest rates, you may also invest in corporate bond funds. The mutual fund is diversified among different bonds and managed by an expert. There is much less risk involved, though mutual funds can still lose value and usually come with extra fees.