Is it Worth Investing in Corporate Bonds? Pros and Cons
The Basics of Corporate Bonds
Corporate bonds are an investment in the debt of a company. They are sometimes also known as loan stock. The company sells bonds to investors. The company then pays interest regularly and returns the original capital at the end of the term.
For example, if company X issued a ten year bond for $100 a go paying interest of 3% at the end of each year then if you bought that bond you would get $3 a year in interest and then your $100 back (and a nice $3 interest payment) at the end of the ten years.
The interest payments are sometimes called coupons. In reality, a lot of bonds pay their coupons twice a year. The effective return on the bond, based on the price, is called the yield.
Good Points of Corporate Bonds
The good things about corporate bonds are:
- Predictable income: You know what the bond will pay (so long as the company doesn't go bust) assuming you don't need to sell the bond before the end of the term.
- More security: You come ahead of the shareholders if the company does go bust, so your money is more secure than shares in the same company.
Potential Bad Points of Corporate Bonds
Some of the downsides are:
- If the company goes bust you may not get all (or even any) of your money back.
- If inflation is high it might reduce the spending power of your money so once you do get it back it doesn't go as far. This is more of a problem for bonds because:
- There is less scope for a large capital gain on the bond, the way there is with shares. If inflation is high share prices often go up with general prices.
- On average the return you get on a bond is lower than for a share in the same company because a bond is less risky (you get your money back before the shareholders do). (It's a basic fact of investing that lower risks come with lower returns).
- If you do need to sell the bond before the end of the term you may not get your money back as prices can go up and down over time.
It's worth learning more about the principles of investing. For example:
Income and capital gains are the two ways of getting a return on an investment. For bonds the regular interest (or "coupon") payments are income. But if the bond changes price and you sell it for more than you bought it for that's a capital gain.
Learn more about the difference between investment income and capital gains in this article.
Bonds, for Retail Investors?
Corporate bonds are given ratings by rating agencies. The higher the rating the less likely the company is to not pay your money back. Bonds with low ratings are called junk bonds. They pay high rates of interest but there is a high chance of not getting your money back.
For most retail investors you won't invest directly in corporate bonds because they don't come in small enough amounts. Instead, you invest in a bond fund run by a professional manager. They will often track a particular published bond index. Or they may specialise in a particular area—for example in Japanese bonds or in junk bonds from Argentina.
Another Option for Regular Income
Preference shares (also known as preference stock or 'prefs') are shares that pay a set dividend and are more secure than ordinary shares. They are not very well known, but can be a higher return (and higher risk) alternative to corporate bonds.
You should always think carefully about your investments. Nothing on this page is financial advice. You may want to take advice from a professional before investing. Investing always carries risks, including the risk of missing out on other investment opportunities.
Having said that bonds can be a useful part of your investment portfolio. They are often seen as less exciting than investing in shares but in the right circumstances, corporate bonds can give you a steady income over the years.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2012 Cruncher