Corporate Bonds

Benefits of Investing in Corporate Bonds

The principal benefits of investing in Corporate Bonds are:

• Attractive yields - Corporates usually offer higher yields than comparable-maturity government bonds or CDs. However, this high-yield potential is generally accompanied by higher risks.
• Dependable Income - Clients who want steady income from their investments may include corporates bonds in their portfolios.
• Quality - Corporate bonds are evaluated and assigned a rating based on credit history and ability to repay obligations.  The higher the rating (Investment grade), the safer the investment as measured by the likelihood of repayment of principal and interest.
• Diversity - Corporate bonds provide an opportunity to choose from a variety of sectors, structures and credit-quality characteristics to meet your investment objectives.
• Liquidity - If you must sell a bond before maturity, in most instances you can do so easily and quickly because of the size and liquidity of the market.

Risk of Investing in Corporate Bonds

Corporate bonds generally have a higher risk of default when compared to government bonds.  This risk depends upon the particular corporation issuing the bond,  current market conditions, industry changes affecting the company, changes in government laws/regulations and the credit rating of the company.  Corporate bond holders are compensated for this risk by receiving a higher yield than government bonds.

The most important risks associated with Corporate bonds are:

• Default Risk - The risk associated with the issuer not being able to meet all of its debt obligations.
• Credit Spread Risk - The risk that the credit spread of a bond (extra yield to compensate investors for taking default risk), which is inherent in the fixed coupon, becomes insufficient compensation for a future increase in the default risk.
• Interest Rate Risk - The general level of yields in a bond market, as expressed by government bond yields, may change and thus bring about changes in the market value of fixed-coupon bonds so that their yield to maturity adjusts to newly appropriate market levels.
• Liquidity Risk - There may not be a continuous secondary market for a bond, thus leaving an investor with difficulty in selling at, or even near to, a fair price.
• Supply Risk - Heavy issuance of new bonds similar to the one held may depress their prices.
• Inflation Risk - Inflation reduces the real value of future fixed cash flows. An anticipation of inflation, or higher inflation, may depress prices immediately.
• Tax Change Risk - Unanticipated changes in taxation may adversely impact the value of a bond to investors and consequently its immediate market value.
• Currency Exchange Risk - If the bond is denominated in local currency, changes in the foreign exchange rate will have an impact on future cash flows.

Corporate Bond Term

One key investment feature of any bond is its maturity. A bond's maturity tells you when you should expect to get your principal back, and how long you can expect to receive interest payments.

In general, Corporate bonds can be divided into three maturity groups:

• Short-Term - These are bonds with maturities of up to 5 years.
• Medium-Term - Bonds with maturities between 5 and 12 years.
• Long-Term - Bonds with maturities greater than 12 years.

Relationship between Bond Price and Interest Rates

Like all bonds, corporate bonds tend to rise in value when interest rates fall, and they fall in value when interest rates rise. Usually, the longer the maturity, the greater the degree of price volatility. If you hold a bond until maturity, you may be less concerned about these price fluctuations (which are known as interest-rate risk, or market risk), because you will receive the par, or face, value of your bond at maturity.

When interest rates rise, new issues come to market with higher yields than older securities, resulting in those older securities being worth less.  Hence, their prices go down.  When interest rates decline, new bond issues come to market with lower yields than older securities, resulting in those older, higher-yielding securities being worth more. Hence, their prices go up. As a result, if you have to sell your bond before maturity, it may be worth more or less than you paid for it.

Various economic forces affect the level and direction of interest rates in the economy.  Interest rates typically climb when the economy is growing, and fall during economic downturns. Similarly, rising inflation leads to rising interest rates (although at some point, higher rates themselves become contributors to higher inflation), and moderating inflation leads to lower interest rates. Inflation is one of the most influential forces on interest rates.

Understanding Yields

Yield is a critical concept in bond investing, because it is the principal tool used to measure the investment return.

Yield is the internal rate of return of all the cash flows on the corporate bond investment.  There are many ways to measure yield, but the most importance Yield calculation to most investors are:

• Yield to Maturity -  Measures the internal rate of return (IRR, overall interest rate) earned by an investor who buys the bond today at the market price, assuming that the bond will be held until maturity, and that all coupon and principal payments will be made on schedule. Yield to maturity is actually an estimation of future return, as the rate at which coupon payments can be reinvested when received is unknown.
• Current Yield - It is the ratio of the annual interest payment and the bond's current price.  The current yield only therefore refers to the yield of the bond at the current moment.  It does not reflect the total return over the life of the bond. In particular, it takes no account of reinvestment risk (the uncertainty about the rate at which future cashflows can be reinvested) or the fact that bonds usually mature at par value, which can be an important component of a bond's return.
• Yield to Call - Measures the total return you would receive if you were to buy and hold the security until the call date.  As an investor, you should be aware that this yield is valid only if the bond is called prior to maturity. The calculation of yield to call is based on the coupon rate, the length of time to the call date, and the market price of the bond.
• Coupon Yield -The coupon yield is simply the coupon payment as a percentage of the face value of the bond.

How Corporate Bonds Are Taxed

The following is general basic information on tax aspects for individuals investing in corporate bonds. For advice about your specific situation, you should always consult with your tax adviser.

• Interest - The interest you receive from corporate bonds is subject to federal and state income tax. (If you own shares in bond mutual funds, your interest income will come to you in the form of “dividends” from the fund, but these are fully taxable and are not eligible for the maximum 15% tax rate that otherwise applies to dividends.)
• Gains and Losses - Clients may generate capital gains on a corporate bond if they sell it at a profit before it matures. If you sell it up to a year from purchase, the gains are taxed at your ordinary rate. If you sell it more than a year from purchase, your capital gains are considered long-term and are currently taxed at a maximum rate of 15%. Conversely, if you sell a bond for less than you paid, you may incur a capital loss. You may offset an unlimited amount of such losses dollar-for-dollar against capital gains you have realized on other investments (bonds, stocks, mutual funds, real estate, etc.).  If your losses exceed your gains, you may currently deduct up to $3,000 of net capital losses annually from your ordinary income. Any capital losses in excess of $3,000 are carried forward and can be used in future years. (These rules apply to the sale of shares in bond funds as well as to individual bonds.)

• Investment Management
• Fixed Income Managed Accounts