How To Choose A Corporate Bond For IncomeAugust 30th, 2012 by David Waring
One of the main reasons to buy individual corporate bonds instead of bond funds is income. While both bond funds and individual corporate bonds deliver income, an individual bond will provide a fixed dollar payment on a regular basis, which does not fluctuate. The income generated by bond funds will fluctuate based on changes in the funds holdings and changes in market rates. As a result, many investors looking for a predictable income stream prefer individual bonds over funds. You can learn more about bonds vs. bond funds here.
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When buying an individual corporate bond there are three basic considerations:
We are going to walk you through how to think about these issues below. However, you are going to have to make several judgement calls. If you are not comfortable making these decisions, you should consider working with a financial advisor or buying a fund.
Finding The Highest Yield
How long the bond has until maturity will have a major impact on yield. Normally the longer the bond has until maturity the higher its yield. However, there are normally also reasons why you might not want to go for the bond with the longest time until maturity. We outline why below.
Finding the Right Balance Between Risk and Yield
The safer the bond, the lower the yield. Or conversely, investors get paid to take on more risk. As a rule of thumb, you don’t want to be taking lots of risk if you are only holding a few bond issues. However, sometimes the extra yield compensates for the risk. We talk more about how to decide what’s best for you below.
Avoiding Bonds That Are Likely To Be Called
If you buy bonds that are trading above their face value and they are called, you will lose money. As a rule of thumb, you want to avoid buying bonds that are callable at face value in the next couple years and trading at a big premium to face value. There is a quick and dirty way to prevent this situation: Avoid bonds that have a big difference between their yield to worst and yield to maturity. While you may miss out on some good bonds with this method, you will also not be surprised by having your bonds called. You can learn more about callable bonds here.
Step 1: Look at the yield curve and decide how much interest rate risk you are willing to take.
Each day we update the treasury yield curve here at Learn Bonds which you can find here. The rates for corporate bonds are going to be higher than the rates for treasury bonds, however the shape of the yield curve should be similar. You can therefore look at the treasury yield curve for an understanding of the relative yields of longer term compared to shorter term corporate bonds.
Here are the yields for different maturities on the day this article was written:
You can find the latest treasury yields here.
As you can see from the above table, we are currently in a very low interest rate environment. However, there is some steepness to the yield curve, meaning that you are earning more interest on longer term bonds. The 5 year treasury is currently yielding almost 3 times the two year. Going out to 10 years you are earning more than double what you earn on the 5 year. Basically, among these timeframes, you are getting a good amount of extra yield for extending your maturities out for longer periods of time.
However, once you get out beyond 10 years, the amount of extra return you receive for the longer maturity bonds starts to diminish. In fact for tripling the time until maturity between a 10 year and a 30 year bond, you are getting less than double the yield. As many things can happen over a 20 year period, it does not seem worth locking your money up for an extra 20 years without being compensated a lot more than is currently being offered. So with the current yield curve it seems that the intermediate term 5 to 10 year maturity range is likely where we want to be positioned.
Step 2: Decide how much credit risk you are willing to take.
As we discuss in our article “Can you trust corporate bond credit ratings?” investment grade bonds rarely default. We recommend that most investors buy only investment grade bonds. However, there is a large variety of ratings within investment grade, ranging from super-safe AAA to one notch above junk, BBB-. (if you are not familiar with credit ratings go here).
At the end of day, there are two questions an investor must ask with regards to credit risk:
What is the highest amount of credit risk that I am prepared to take? In other words, can I live with a 1/500 risk of default? How about a 1/100? or 1/25? Typically, bond default rates are quoted in terms of defaults per year. However, since bond buyers tend to hold bonds for several years, not one, we believe annual default rates are misleading. We like to use 10 year default rates which measure defaults over a decade (even after a bond may have lost its investment grade rating).
|Starting Rating||10 Year Default Rate|
Step 3: Screen for bonds
Step 4: Choose the bonds you like
When investing in stocks or bonds I am a fan of Peter Lynch’s “invest in what you know” philosophy. So after scanning through the list of top yielding bonds there are three bonds that immediately jump out at me, an American Airlines bond, an Alcoa Bond, and a Safeway bond.
The next thing that jumps out at me is that the American Airlines bond which matures 7/20/19 yields 8.606% where the Alcoa bond maturing 2/23/2022 yields 5.205% and the safeway bond maturing 12/01/2021 yields 5.049%. Like with most other things in finance there are very few if any free lunches among actively traded bonds, so you can be sure that if a bond is yielding that much more that there is a reason for it. In this case, the reason why is that the American Airlines bonds are pro-rata bonds which have recently been put on a negative watch by the ratings agencies. Long story short the reason why they are yielding so much more is that there is something a little fishy. Unless you are the type that wants to get heavy into analysis then a good rule of thumb is to throw out bonds that are yielding substantially more than other bonds with similar ratings and maturities.
Step 5: Check the ratings report
The major online brokers normally give you access to either the moody’s or S&P summary ratings reports. The Moody’s reports are far better, so we recommend using a broker that has those reports available (E*Trade, Ameritrade, and Schwab all do). When looking at the ratings report, you want to make sure that, at a minimum, the bond and issuer are not on watch for a downgrade. Ideally, in addition to not being on watch for a downgrade we would like to see that the bond has actually been upgraded recently. If you want to take things further than this read our article “Do it yourself Credit ratings”.