Choosing Between High-Risk and Investment Grade Corporate Bonds
Corporate bonds are issued by companies or corporations and bought by investors. They are backed by collateral or the company’s ability to earn income from its operations. They carry a higher interest rate because they are riskier than other types of debt instruments.
Characteristics and Types
This is a type of debt financing that is issued in blocks and is used by businesses to raise capital. There are different ways to fund operations and business expansions, including lines of credit, bank loans, and equity and debt financing. Generally, companies can borrow from the general public/investors, take out a loan, or issue shares. One option is to issue bonds, and there are many types to choose from. Some have a call feature meaning that they have an early prepayment option linked to interest rate changes. Other types are convertible and companies can choose to convert them into common stocks. The main advantage is that holders earn interest over a certain period of time, and this type of instrument is less volatile compared to common shares. Many bonds come with a fixed interest rate, which doesn’t change. This means that holders receive a fixed income, which gives them a certain degree of security. Other types offer a floating rate that changes with rate fluctuations. It is tied to some index and is usually lower than that of other types of investment instruments. In addition, there are zero-coupons that pay no interest but are sold at a discount. Holders earn profit at maturity when they can redeem the bonds at full value. For example, investors can buy zeroes for $320 now which have a maturity in 2025 at a face value of $980. The problem is that the money the holder receives might not have the expected purchasing power. This makes zero-coupons risky for the average investor.
Ratings and Risk
There are agencies that assign rating based on risk and other factors. Some bonds carry a high risk, especially those that are sold by companies with a poor credit rating and limited prospects. Other types are considered speculative and are sold by companies that are at a risk of default. This is called high-yield debt and attracts investors who are looking for high yields. Holders face a higher maturity, liquidity, repayment, and credit risk. Also known as junk bonds, they offer a fixed interest rate but are considered a risky investment. They have a rating of BB and many financial entities, including insurance companies, banks, and pension funds, are not allowed to invest in speculative instruments. Other types of bonds are classified as investment grade and have a rating of BAA. They are not poorly secured but do not offer a high level of protection. Good options for investors are obligations that carry a small risk and have a rating of AA or AAA.
Generally, individuals that invest in debt securities face tax, supply, liquidity, and default risk. Prices may fall if a company decides to issue a large number of new bonds. Given that most debt instruments offer a fixed interest rate, investors are exposed to inflation risk. The value of future profits decreases due to inflation.
Pros and Cons of Debt Securities
The main advantage for investors is that they have a steady source of income. Stocks, for example, are more volatile than, which makes them a riskier investment. Investors make profits by selling debt securities when their price increases. Moreover, financially stable, established companies offer high-rated bonds with a low degree of investment risk. Some securities have a long maturity, and their price may fall with interest rate fluctuations. In addition, some issuers are unable to pay back to investors who lose their money. Debt securities that have a rating of D are in default.
While some issuers offer high interest rates, there are other, safer investment instruments. Government bonds are one example. Treasury bonds are not rated, but they are backed by the government, and repayment is guaranteed. Investors can choose from different types, including government savings bonds, debt restructuring bills, and zero coupon treasury and municipal bonds. The latter are offered by municipalities that seek to finance infrastructural and other projects. Municipalities need funding for their daily operations and offer a large variety of debt securities, including student loan, seaport revenue, hospital, university, and airport revenue bonds. These types are safer than corporate debt securities because they are backed by tax revenue.
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