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When companies want to expand operations or fund new business ventures, they often turn to the corporate bond market to borrow money from investors. A company determines how much it would like to borrow and then issues a bond offering in that amount; investors that buy a bond are effectively lending money to the company according to the terms established in the bond offering known as the bond covenants.Characteristics of corporate bonds Over the years, the corporate bond market has attracted many investors seeking higher yields than those offered by government bonds. In general, corporates are the second largest sector in the bond market after government bonds. Unlike equities, ownership of corporate bonds does not signify an ownership interest in the company that has issued the bond. Instead, the company pays the investor a rate of (taxable) interest over a period of time and repays the principal at the maturity date established at the time of the bond’s issue. While some corporate bonds have redemption or call features that can affect the maturity date, most are loosely categorized into the following maturity ranges:
Corporate bonds share several other vital characteristics, including:
The corporate dividing line: Investment-grade vs. speculative-grade bonds Corporate bonds have a wide range of ratings, reflecting the fact that the financial health of issuers can vary widely. Corporate bonds fall into two broad credit classifications: investment-grade and speculative-grade (or high yield) bonds. Speculative-grade bonds are issued by companies perceived to have a lower level of credit quality compared to more highly rated, investment-grade, companies. The investment-grade category has four rating grades while the speculative-grade category is comprised of six rating grades. Historically, banks were only allowed to invest in bonds in the four highest categories (hence the term “investment grade”) while the companies with the bottom six ratings were generally considered too risky and speculative for financial institutions.
Historically, speculative-grade bonds were issued by companies that were newer, were in a particularly competitive or volatile sector or had troubling fundamentals. Today, there are also many companies whose businesses are designed to operate with the degree of leverage traditionally associated with speculative-grade companies. While a speculative-grade credit rating indicates a higher default probability, these bonds typically compensate investors for the higher risk by paying higher interest rates, or yields. Credit ratings can be downgraded if the credit quality of the issuer deteriorates or upgraded if fundamentals improve.Fallen angels, rising stars and split ratings “Fallen angel” is a term that describes an investment-grade company that has fallen on hard times and has subsequently had its debt downgraded to speculative grade. “Rising star” refers to a company whose bond rating has been increased by a credit agency due to an improvement in the credit quality of the issuer. Since the credit agencies’ ratings are subjective, there are also times when they do not concur on the rating – an occurrence known as a “split rating.” Fallen angels, rising stars and split ratings may all present opportunities for investors to add additional yield by assuming greater risk due to the potential volatility of their ratings. The basics of corporate bond pricing The price of a corporate bond is influenced by several factors, including the maturity, the credit rating of the company issuing the bond and the general level of interest rates. The yield of a corporate bond fluctuates to reflect changes in the price of the bond caused by shifts in interest rates and the markets’ perception of the issuer’s credit quality. Most corporates typically have more credit risk and higher yields than government bonds of similar maturities. This divergence creates a credit spread between corporates and government bonds, so that the corporate bond investor earns extra yield by taking on greater risk. The credit spread affects the price of the bond and can be graphically plotted and measured as the difference between the yield of a corporate and government bond at each point of maturity along the yield curve. Conclusion: Corporate bonds offer potential benefits Corporate bonds can broaden a risk profile and diversify a portfolio of equities and/or government bonds depending on the economic environment, the credit rating of the bond issuer and the investor’s level of risk tolerance. In addition, they may offer investors the potential for steady income and attractive yields.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not.
This material contains the opinions of manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2012, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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