In this age of low returns on certificates of deposit and jitters over the stock market, many investors wonder where to put their money. One option is corporate bonds. Corporations issue bonds to finance expansion or acquisition of other firms. According to the Securities Industry and Financial Markets Association, the value of U.S. corporate bonds was $1.36 trillion in 2012.
Corporate bonds carry a much greater risk of default than U.S. government bonds, and when issued by firms with poor credit ratings, they are called “junk bonds.” Treasury bonds are backed by the full faith and credit of the United States government, whereas corporate bonds rely on a firm’s ability to pay back bondholders.
Bond Ratings. Bond ratings are based on the overall risk that the issuer will default. AAA-rated bonds have a very low risk of default. Bonds issued by the U.S. Treasury fall into this category. Generally, bonds rated AAA to BBB are considered “investment grade,” meaning that the chance of default is small. Bonds rated BB+ to BB- are considered “noninvestment grade,” or junk bonds, and carry some risk of default. As the risk rises, the bond rating drops. Bonds rated DDD to D are in default. The three major bond-rating firms — Moody’s, S&P and Fitch — do not always assign the same rating to the same risk. Indeed, sometimes one firm “downgrades” a certain bond while the other two firms do not. However, their ratings are generally close.
Corporate bond ratings also change over time. For instance, last April Fitch raised ratings for bonds issued by Ford Motor Company and its Ford Motor Credit subsidiary from double-B plus (“junk”) to triple B-minus (investment grade), based on the company’s debt reduction and profitability.
Yields on Corporate Bonds Relative to Treasury Bonds. Corporations typically issue bonds for periods ranging from one year to 30 years. As with stocks, bonds are traded on the open market. Whether sold by a firm or the government, bonds usually pay a fixed rate of interest (also referred to as coupon payment) quarterly, semi-annually or annually until maturity. When the bond matures, the issuer pays the principal amount to the purchasers. In the interim, however, a bond purchaser can sell the bond to anyone in the so-called secondary market.
Suppose a firm issues a $1,000 bond that pays 6 percent annually for the next 5 years. If the firm later issues bonds that pay a lower interest rate (say, 5 percent annually) the bondholder may sell his 6 percent bond at a premium on the secondary market for more than its face value. Why? Because bond buyers will prefer the 6 percent bond over the newly-issued 5 percent bond, thus increasing the $1,000 bond price. If investors become risk-averse and the demand for bonds increases, the interest rate on bonds in the primary market falls.
Risk of Default. Bond defaults in the United States have been characterized by periods of low and highs that do not necessarily correlate with economic growth or the business cycle. A study by Kay Giesecke of Stanford University and her colleagues found [see the figure]:
- The largest default occurred from 1866 to 1899, when on average 4 percent of the value of bonds issued defaulted each year.
- From 1900 to 1945, average annual defaults fell to 1.3 percent.
- Post-World War II, from 1946 to 2008, the average annual default rate fell to its lowest level at 0.30 percent of all bonds issued.
Even during the junk bond scandal of 1990, only 1.5 percent of junk bonds defaulted. Since then the largest corporate bond default period took place during the dot.com crisis from 2001 to 2002, when an average of 2.5 percent of bonds defaulted.
Rate of Return on Corporate Bonds. How have corporate bonds performed relative to other investments? The “spread” between a corporate bond and a Treasury bond is the difference between the interest rate each pays. For instance, if a one-year corporate bond pays 5 percent annually and a one-year Treasury bond pays 1 percent annually, the spread is 4 percentage points. The greater the spread between the two, the higher the risk of the corporate bond. The spread between Treasury bonds and corporate bonds in 2012 was 1.63 percentage points, lower than the historical average spread of 2 to 5 percentage points.
The rate of return on a bond also includes any capital gain or loss resulting from selling the bond before its maturity. The table shows the rates of return for four corporate bond funds with a minimum of $2 billion in assets, and a Treasury bond index fund. Compare their annual rates of return during the past five years [see the table]:
- In 2008, the returns on the corporate bond funds were negative, ranging from -11.8 percent to -36.1 percent, while the longer-term Treasury bond fund yielded 10.2 percent.
- In 2009, however, the corporate bond funds rebounded substantially, with yields ranging from 31.6 percent to 74.8 percent, while the Treasury bond fund fell into negative territory (-2.5 percent).
- In 2012, the Treasury bond fund returned 0 percent for the year, while one corporate bond fund experienced double-digit gains.
Despite the greater risk, the corporate bond funds had greater return potential than the Treasury bond fund. Thus, like the stock market, the bond market experiences highs and lows because so many bonds are traded on any given day.
Conclusion. Investors, particularly retirees looking for steady returns on their retirement income, are frustrated by the low rates of return on Treasury bonds. With current short-term bonds currently paying less than 1 percent annually — only seven-year and longer-term bonds pay more than 1 percent — investors looking for decent returns but who are reluctant to buy stocks may want to consider corporate bond funds.
Pamela Villarreal is a senior fellow at the National Center for Policy Analysis.