Corporate Bonds/Higher Yields - What Else Should You Know?

Corporate bonds have been tempting investors by offering higher yields in a time of historically low interest rates, but experts warn there’s a lot more to that story.

“The corporate bond market is large and liquid with daily trading volume estimated at $15.1 billion,” according to the SIMRA – the Securities Industry and Financial Markets Association – on its InvestinginBonds.com website. “Corporates usually offer higher yields than comparable maturity government bonds or CDs.”

But higher yields come with higher risks, say the experts, who also point out that total returns on corporate bonds are lowered by taxes and fees, as well as risk factors such as default. The yields – after expenses – may not look so impressive, especially to investors in the highest tax brackets, who may have more to gain from federally tax-exempt municipal bonds.

Historical data from the website BondsOnline shows 10-year yields for the top, AAA-rated corporate bonds at 2.08 percent at the end of December, while BBB-rated - or investment-grade bonds - yielded 6.24 percent. Over the same time period, Treasuries yielded 1.85 percent, as did AAA-rated municipal bonds.

Tax-free municipal bonds have long been the preferred fixed-income product for the ultra wealthy, according to Millionaire Corner research. At the end of 2011, close to half (46 percent) of Ultra High Net Worth investors – defined as those with a net worth of $5 million to $25 million not including primary residence - owned individual municipal bonds for an average balance of $500,000. In contrast, 37 percent owned individual corporate bonds for an average balance of $358,000.

The suitability of corporate bonds depends on several factors, including an investor’s appetite for risk, desire to diversify among fixed-income products, and need to preserve assets balanced against the need for growth and income. Investors can lose sight of these fundamentals in their search for yield.

“The single biggest mistake bond investors make is reaching for yield after interest rates have declined,” said the Financial Insurance Regulatory Authority or FINRA. “Yield is one of many factors an investor should consider when buying a bond. And never forget: With higher yield comes higher risk.”

Corporate bonds are generally lumped into two broad categories – investment grade and non-investment grade, said FINRA. Ratings are provided by three key agencies, Standard and Poor’s, Moody’s and Fitch. A rating of BBB, bbb or Baa or higher is considered investment grade and “safer” than junk bonds.

“Junk bonds are considered riskier investments because the issuer’s general financial condition is less sound,” said FINRA.  This means a corporation my not be able to pay interest or return underlying principal to a bondholder when the payments are due. In addition to this risk of default, corporate bonds also face risks from fluctuations in prevailing interest rates and some are called before maturity. Despite their risks, corporate bonds and their higher yields have played a historic role in wealth building.