How To Choose A Corporate Bond For Income

August 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:

The issuer does not default.
Getting the highest yield.
The bond’s callability before maturity.

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
AAA	0.71%
AA	0.87%
A	2.18%
BBB	5.90%

How much risk are you are willing to take?Once you decide on the most risk that you are comfortable taking, then the question becomes how much risk should you take. To aid in this process most bond brokers offer a table and/or chart which shows the yields for corporate bonds of different maturities and different ratings so you can get an idea of how much extra compensation you can potentially receive for bonds with different credit ratings. This screenshot which I took from E*Trade is what that looks like:

Form looking at this chart you will notice that the yield differences between the different credit ratings are not stable, For example, over a year the difference in yield between AAA and AA corporate bonds basically disappeared. On the other hand, A and BBB yields were almost the same at the beginning of the year but widened at the end of the year. What happened? The market changed its perception of credit risk. In The market’s view AA bond became less risk over the year and BBB bonds became more risky. (To learn more visit our article on the basics of credit spreads)

When you choosing a bond credit rating, you are basically saying that you don’t think the market is correct in pricing the extra risk. In the chart, BBB bonds are paying around 2.5% more than double AA bonds. If you think that BBB will default less than 2.5% more that AA bond, then you might want to purchase them (as long as they fall within your risk comfort level.)

Step 3: Screen for bonds

All of the major online brokers offer screeners which allow you to filter for bonds based on that maturity date and credit risk criteria we are concerned with. Here is what E*Trade’s basic screener looks like (there is also an advanced version of this with additional options):

For rating I am going to screen for bonds which are rated from the lowest investment grade rating, to the highest. For maturity I am going to screen for bonds which mature in 5 to 10 years. I am also going to screen for non callable bonds.Once that screen comes back I can then sort the results from highest yield to lowest yield. After doing this you are almost always going to see a lot of financial bonds that are the highest yielders. There are a number of reasons for this which you can learn more about in our article “Financial Bonds: Lower Default Rates AND Higher Yields”. If you are open to financial bonds then you can leave the screen as is, if not then the advanced screener for most firms will allow you to filter out financial bonds. For me personally I do not want financial bonds so I filter them out.

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”.

This lesson is part of our Free Guide to Investing in Corporate Bonds. Continue to the next lesson here.