How To Tell If a Corporate Bond Is a Good Investment with Sam Nofzinger, GM of Brokerage at Public
On this episode of the Money Rehab podcast, Sam Nofzinger, GM of Brokerage at Public, explains what corporate bonds are and how to evaluate them as an investment option. He describes how corporate bonds work, with investors lending money to companies in exchange for periodic interest payments and the return of principal at maturity.
Nofzinger breaks down key factors like risk levels, maturity dates, and security in assessing corporate bonds. He also provides insights into how corporate bonds can complement equity investments in a diversified portfolio, offering potentially higher returns than cash or Treasuries but with increased default risk. Whether interested in individual corporate bonds or bond ETFs, this episode offers a straightforward overview to consider this income-generating asset class.
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1-Page Summary
What are Corporate Bonds?
Core Definition
According to Sam Nofzinger, corporate bonds represent loans that investors provide to companies, allowing those companies to raise funds for operations and activities. Unlike issuing new stock, which dilutes equity, issuing bonds lets companies avoid that dilution.
Comparison to Other Bonds
Compared to government bonds, corporate bonds carry more risk but offer higher potential returns. This higher risk accounts for the possibility that the issuing company could default. The issuer of corporate bonds can be any corporation, public or private, whereas government bonds come solely from state entities.
How Corporate Bond Investing Works
Investing Process
When purchasing a corporate bond, the investor pays a principal amount (e.g. $100) and then receives periodic interest payments (e.g. $5 annually) until the bond matures. At maturity, the investor is repaid the principal plus any final interest.
Risk and Return
Corporate bonds typically offer higher yields than government bonds to compensate for their increased risk. According to Nofzinger, investment-grade bonds rated BBB- and above are lower-risk, while "junk" bonds rated BB+ and below are higher-risk but can offer yields from 7-8% up to 20-40%.
Key Evaluation Factors
Maturity
Nofzinger highlights maturity date as a crucial risk factor - shorter-term bonds are less risky than long-term bonds. Callability also impacts risk, as callable bonds allow the issuer to redeem before maturity.
Security
As Lapin explains, secured bonds backed by assets like real estate offer more protection than unsecured bonds which rely solely on the issuer's promise of repayment.
Corporate Bonds in a Portfolio
Complement to Equities
Corporate bonds can serve as a lower-risk, income-generating balance to equity investments in a diversified portfolio, according to Nofzinger.
Potential Returns
Compared to cash/Treasuries, corporate bonds offer potentially higher returns but more default risk. Bond returns come from interest payments and potential price appreciation if interest rates decline.
Investment Options
Nofzinger notes investors can purchase individual corporate bonds or corporate bond ETFs to access that income stream and capital preservation in a straightforward way.
1-Page Summary
Additional Materials
Clarifications
- When a company issues new stock, it sells ownership stakes in the company, diluting existing shareholders' ownership. On the other hand, when a company issues bonds, it is essentially taking out a loan from investors and promising to repay the borrowed amount with interest. This distinction is crucial as issuing new stock affects ownership while issuing bonds involves taking on debt.
- Corporate bonds typically carry more risk than government bonds because companies issuing corporate bonds are considered more likely to default on their debt obligations compared to government entities. This higher risk is reflected in the potentially higher returns offered by corporate bonds to compensate investors for taking on this increased level of risk. Government bonds, on the other hand, are generally considered safer investments because they are backed by the government's ability to tax and print money, making them less likely to default.
- Investment-grade bonds are considered lower-risk and are rated BBB- and above, indicating a higher likelihood of repayment. "Junk" bonds, rated BB+ and below, are higher-risk with a greater chance of default but offer higher yields to compensate for the risk. The distinction between these categories helps investors assess the risk level and potential returns of corporate bonds.
- A callable bond gives the issuer the option to redeem the bond before its maturity date. This feature allows the issuer to benefit from lower interest rates by refinancing the debt. Investors receive higher coupon payments as compensation for the risk of early redemption. If interest rates decrease, the issuer is more likely to call the bonds to issue new ones at a lower rate.
- Secured bonds are backed by specific assets that the issuer pledges as collateral, providing more security to bondholders in case of default. In contrast, unsecured bonds, also known as debentures, do not have specific collateral backing them, relying solely on the issuer's creditworthiness for repayment. The presence of collateral in secured bonds gives investors a higher chance of recovering their investment if the issuer fails to meet its obligations. Unsecured bonds are riskier for investors as they have no specific assets to claim in case of default.
- Corporate bonds can complement equity investments by providing a lower-risk component to a diversified portfolio. While equities offer potential for higher returns but come with higher volatility, corporate bonds offer steady income through interest payments and can act as a buffer during market downturns. By holding a mix of both asset classes, investors can balance risk and return in their investment portfolios.
- When comparing potential returns and default risk of corporate bonds to cash/Treasuries, it's important to note that corporate bonds generally offer higher returns than cash and Treasuries due to their higher risk profile. However, this increased return potential comes with a greater risk of default, meaning there is a possibility that the issuing company may not be able to repay the bond's principal amount or interest payments as promised. This risk of default is why corporate bonds typically offer higher yields to investors compared to safer assets like cash or Treasuries.
Counterarguments
- While corporate bonds typically offer higher yields than government bonds, this is not always the case, especially during periods of economic uncertainty when the demand for safer assets can drive down yields on government bonds to levels comparable to or even below those of corporate bonds.
- The assertion that corporate bonds can raise funds without diluting equity overlooks the fact that if a company is unable to meet its debt obligations, it may have to restructure its debt, potentially leading to equity dilution if debt is converted to equity.
- The idea that secured bonds offer more protection than unsecured bonds is generally true, but in the event of a company's bankruptcy, even secured bondholders may face significant losses, depending on the value and marketability of the underlying assets.
- The statement that corporate bonds can complement equity investments in a diversified portfolio is a common investment strategy, but it does not account for scenarios where bond and stock markets may be correlated, reducing the diversification benefit.
- The notion that callable bonds are riskier because they can be redeemed before maturity does not consider that callable bonds typically offer higher yields to compensate for this risk, and some investors may find the trade-off acceptable or even desirable.
- The suggestion that corporate bonds offer capital preservation may be misleading, as bond prices can fluctuate, sometimes significantly, due to changes in interest rates, credit ratings, or market sentiment, leading to potential capital loss if sold before maturity.
- The potential returns from corporate bonds compared to cash/Treasuries are highlighted, but it is important to note that during periods of deflation or very low inflation, the real return of cash or Treasuries could be comparable to or exceed that of corporate bonds after adjusting for risk.
- The recommendation to invest in corporate bond ETFs for straightforward access to income and capital preservation may not fully acknowledge the management fees and other costs associated with ETFs, which can erode returns over time.
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Corporate bonds: definition, purpose, and differences from other bond types
Sam Nofzinger sheds light on corporate bonds—a financial tool used by companies to raise funds—and explains how they differ from other types of bonds.
Corporate bonds are loans that companies offer to investors to raise funds.
A corporate bond represents a loan from the investor to the company. Companies such as Apple, Nvidia, or Microsoft issue bonds to obtain funding for various purposes including their operations and activities. This method of fundraising allows companies to avoid diluting equity, which would occur if they issued additional stock.
Corporate bonds differ from government bonds and other fixed-income investments in terms of risk, return, and the issuer.
Nofzinger points out that compared to government bonds, corporate bonds entail more risk due to the possibility of the issuing company defaulting. However, they offer higher potential returns to compensate investors for this additional risk. The issuer of corporate bonds can be any corporation, either public or private, contrasting with government bonds which are exclusively issued by state entities.
Details of investing in corporate bonds
When purchasing a corporate bond, an investor pays a certain amount of money, for instance, $100, and receives periodic interest payments, say $5 every year, until the bond reaches maturity. At maturity, the investor is repaid the principal amount plus any final interest payment. This differs from owning stock, where an investor gains an ownership stake in the company and possibly dividends, but not a guaranteed repayment of capital or fixed interest.
Comparison with government bonds and diversification
Nofzinger discusses diversification in the context of bonds, highlighting the option of including both corporate bonds and treasuries in a portfolio. He explains the differences in the impact of interest rate ch ...
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Corporate bonds: definition, purpose, and differences from other bond types
Additional Materials
Clarifications
- Corporate bonds are essentially debt securities issued by companies to raise capital. When an investor buys a corporate bond, they are lending money to the issuing company in exchange for periodic interest payments and the repayment of the principal amount at maturity. This loan structure distinguishes corporate bonds from stocks, where investors own a portion of the company. The company promises to repay the bond's face value (the principal) at a specified future date, known as the maturity date, along with periodic interest payments until that time.
- Corporate bonds typically offer higher potential returns than government bonds to compensate investors for the additional risk they carry due to the possibility of the issuing company defaulting. Government bonds are generally considered safer because they are backed by the government's ability to tax and print money, making them less risky but with lower potential returns compared to corporate bonds.
- When an investor buys a corporate bond, they pay a set amount upfront, like $100, and receive regular interest payments, such as $5 annually. Upon the bond's maturity, the investor gets back the initial investment (principal) along with any final interest payment. This differs from stock ownership, where returns are based on dividends and capital appreciation, not fixed interest payments.
- When the Federal Reserve changes its interest rates, it can have varying effects on different types of bonds. Short-term government bonds are more immediately impacted by these rate changes compared to long-term government bonds and corporate bonds. This is ...
Counterarguments
- Corporate bonds, while offering higher returns, may not always be the best choice for risk-averse investors, as the higher potential returns are directly linked to higher risks, including credit risk and market risk.
- The assertion that corporate bonds are categorically riskier than government bonds may oversimplify the comparison, as the risk profile of corporate bonds varies widely depending on the creditworthiness of the issuing company.
- The idea that corporate bonds avoid diluting equity might be misleading, as it implies that issuing bonds is always preferable to issuing stock, which is not necessarily the case; the decision depends on the company's financial situation, market conditions, and strategic goals.
- The statement that investors receive periodic interest payments until maturity does not account for zero-coupon bonds, which do not offer periodic interest payments but are sold at a discount and pay the face value at maturity.
- While diversification is generally a sound investment strategy, the text does not address the potential downsides of over-diversification, such as reduced potential for higher returns or the complexity of managing a highly diversified portfolio.
- The impact of Federal Reserve rate changes on bonds is more complex than the text suggests; for instance, expectations of future rate change ...
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Corporate bond credit ratings and yields: how they work and the risk/return tradeoff
Credit rating agencies such as Moody's and S&P Global play a critical role in evaluating the creditworthiness of corporate bond issuers by assigning letter grades that reflect different levels of risk.
Credit rating agencies like Moody's and S&P evaluate the creditworthiness of corporate bond issuers and assign letter grades.
Credit rating agencies have thousands of analysts who review the details of every bond issuance and the issuer's financial profiles to grade the debt. These grades range from AAA, AA, and single A to BBB. Bonds rated at BBB- and above are considered to be of investment-grade and represent a lower risk to bondholders.
Investment-grade corporate bonds (BBB- and above) have lower risk but also lower yields, while high-yield or "junk" bonds (BB+ and below) have higher risk but also higher potential returns.
Bonds classified as investment grade, including grades like AAA, AA, A, and BBB, are seen as lower-risk bonds. On the other hand, bonds rated as "junk," such as those with single B and C ratings, offer higher potential returns due to the increased risk associated with the issuer's financial stability.
The yield on a corporate bond is directly related to its credit rating - higher-risk bonds offer higher yields.
The risk associated with a company’s debt is evaluated based on factors such as the company's profitability and the amount of existing debt. High debt levels can strain a company's ability to meet bond interest obligations, which may lead to a lower credit rating and classify the bonds as high-yield and high-risk. High-yield bonds often command significantly higher returns, such as 20%, which compensate for the increased likelihood of issuer default.
Investors must balance the risk and return when selecting corporate bonds, as higher-yielding bonds come with greater default risk.
Sam Nofzinger explains the yield-risk correlation in corporate bonds by stating that places like AAA rated bonds might offer y ...
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Corporate bond credit ratings and yields: how they work and the risk/return tradeoff
Additional Materials
Clarifications
- Credit rating agencies like Moody's and S&P use letter grades to assess the creditworthiness of corporate bond issuers. The highest ratings typically start with AAA, indicating the lowest credit risk, followed by AA, A, and BBB for investment-grade bonds. Ratings below BBB are considered speculative or "junk" bonds, with grades like BB, B, and C reflecting higher levels of credit risk. The specific letter grades provide investors with a standardized way to evaluate the risk associated with investing in corporate bonds.
- The credit rating of a corporate bond indicates the issuer's creditworthiness and risk level. Higher-rated bonds typically offer lower yields as they are considered safer investments. In contrast, lower-rated bonds, often referred to as "junk" bonds, offer higher yields to compensate for the increased risk associated with investing in them. Investors must balance the tradeoff between risk and return when selecting corporate bonds, considering the relationship between credit ratings and bond yields.
- Investment-grade bonds are considered lower risk and have higher credit ratings (BBB- and above), indicating a lower likelihood of default. High-yield or "junk" bonds have lower credit ratings (BB+ and below), signifying a higher risk of default but offering potentially higher returns to compensate for the increased risk. The distinction lies in the creditworthiness of the issuer, with investment-grade bonds being more stable and secure investments compared to high-yield bonds, which carry more risk due to the financial instability of the issuing companies.
- Factors that influence the risk associated with a company's debt and impact credit ratings include the company's profitability, existing debt levels, and ability to meet interest obligations. High debt levels can strain a company's financial health, leading to lower credit ratings and higher-risk classifications. Credit rating agencies assess these factors to determine the likelihood of issuer default and assign appropriate credit ratings accordingly. These ratings help investors gauge the risk level associated with investing in corporate bonds issued by the company.
- When selecting corporate bonds, investors must consider the tradeoff between risk and return. Higher-risk bonds typically offer higher yields to compensate for the increased likelihood of default. It's crucial to strike a balance that aligns with your risk tolerance and investment goals to achieve desired financial outcomes while managing potential losses.
- Junk bonds, also known as high-yield bonds, offer higher potential returns compared to investment-grade bonds due to the increased risk associated with the issuer's financial stability. However, this higher return comes with a greater risk of default, as companies issuing junk bonds are typically less financially stable. Investors in junk bonds must carefully assess the balance between the attractive returns and the heightened risk of potential issuer default. The yields on junk bonds can vary widely, with some offering safer returns around 7-8% and riskier options reaching as high as 20-40%, depending on the issuer's financial health and market conditions.
- When comparing yields between different bond ratings, higher-rated ...
Counterarguments
- Credit ratings are not infallible indicators of risk; they are subject to errors and may not always accurately reflect the issuer's financial health due to factors such as lack of transparency, rapid market changes, or the inherent limitations of the rating methodologies.
- The correlation between credit ratings and yields is not always direct or linear; market dynamics, investor sentiment, and macroeconomic factors can also significantly influence bond yields.
- The dichotomy between investment-grade and high-yield bonds may oversimplify the spectrum of risk; there are many gradations within these categories, and some lower-rated investment-grade bonds may carry risks similar to high-yield bonds.
- The assumption that higher yields always compensate for higher risks may not hold true in all market conditions, especially during times of economic stress when default rates can increase sharply.
- The focus on credit ratings can lead to an overreliance on these assessments, potentially causing investors to overlook other important aspects of bond investing, such as liquidity, covenants, and the overall composition of their investment portfolio.
- The idea that high debt levels invariably lead to lower credit ratings and higher yields does not account for the context in which the debt is incurred; for instance, debt-financed growth can be positive if it leads to higher profitability and cash flow.
- The statement that higher-yielding junk bonds can offer "safer bets" around 7-8% may be misleading, as the term "safer" is relative and such investments can still carry significant risk.
- The assertion that AAA rated bonds might offer yields similar to Tre ...
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Factors to evaluate when investing in corporate bonds (maturity, callability, secured vs. unsecured)
Investing in corporate bonds requires careful assessment of several factors including maturity, callability, and whether the bonds are secured or unsecured. Sam Nofzinger and Nicole Lapin discuss these crucial variables that can significantly influence risk and potential returns.
Maturity date factors
Maturity date is a pivotal factor to consider for bond investors.
Short-term vs long-term bonds
According to Nofzinger, the maturity date of a bond is essential when evaluating risk. Shorter-term bonds are deemed less risky compared to long-term bonds due to the shorter period before repayment. He highlights that investors must consider how long they are willing to have their money locked up—be it short-term (e.g., one to three years) or long-term (e.g., ten to twenty years).
Callable bonds introduce additional risk
Nicole Lapin points out that some bonds are callable, allowing the issuer the option to redeem the bond before the set maturity date, usually at a specified price. She notes that callable bonds can pose a risk to investors because if the bond is called back, investors could be left with cash when interest rates are lower, complicating reinvestment at equivalent yields.
Secured vs unsecured corporate bonds
Secured and unsecured bonds offer different levels of risk and protection.
Secured bond advantages
Secured bonds are typically backed by assets such as real estate, providing more protection for investors in the event of a default. Nofzinger explains that in case of default, the bondholders can claim and sell the assets secured by the bonds.
Unsecured bond ...
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Factors to evaluate when investing in corporate bonds (maturity, callability, secured vs. unsecured)
Additional Materials
Clarifications
- A callable bond gives the issuer the right to buy back the bond before its maturity date. This feature allows the issuer to refinance at lower rates if interest rates drop. Investors receive higher coupons but risk having their bonds called if interest rates decrease.
- Reinvestment at equivalent yields means reinvesting the cash received from a called bond into a new investment that provides a similar level of return. When a bond is called back by the issuer, investors need to find alternative investment opportunities that offer comparable yields to maintain their expected income stream. This process can be challenging if prevailing interest rates are lower at the time of reinvestment, potentially affecting the overall returns on the investment portfolio.
- Bondholders typically have a higher claim on a company's assets compared to stockholders in the event of bankruptcy. This means that if a company goes bankrupt and its assets are liquidated to repay debts, bondholders are paid before stockholders. This priority is based on the legal structure of corporate finance and is designed to protect bondholders who have lent money to the company. Bondholders are considered creditors and have a more secure position in the capital structure than stockholders.
- Bond rating is a measure of the creditworthiness of a bond issuer. It assesses the issuer's ability to repay the bond's principal and interest in a timely manner. Ratings are assigned by credit rating agencies like Moody's, S&P, and Fitch, with higher ratings indicating lower risk and vice versa. Investors use these ratings to gauge the risk associated with a bond inves ...
Counterarguments
- While shorter-term bonds are generally considered less risky due to the shorter period before repayment, this does not account for the potential for higher yields that long-term bonds can offer, which can compensate for the increased risk.
- The willingness of an investor to have money locked up might not only be a function of risk tolerance but also of investment strategy and income needs; some investors may prefer or require longer-term investments.
- Callable bonds do introduce reinvestment risk, but they also typically offer higher coupon rates to compensate for this risk.
- The risk of callable bonds can be mitigated by a well-diversified bond portfolio or by investing in non-callable bonds if reinvestment risk is a significant concern.
- Secured bonds may offer more protection in the event of default, but they often yield less than unsecured bonds, which might not be suitable for investors seeking higher returns.
- The claim that bondholders can sell the assets secured by the bonds in case of default oversimplifies the process, which can be lengthy, costly, and may not always result in full recovery of the investment.
- While unsecured bonds are riskier in the event of a default, they may offer higher yields, and the risk can be offset by investing in bon ...
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Comparing corporate bonds to other investment options
Corporate bonds offer a diverse range of investment opportunities and can be a lower-risk, income-generating complement to equities in a diversified portfolio.
Corporate bonds can serve as a lower-risk, income-generating complement to equity investments in a diversified portfolio.
Corporate bonds are suitable for investors who've built wealth through high-growth stocks and are now looking to moderate their risk exposure. They present a middle ground between the lower risk but also lower yield Treasuries and the higher risk equities, offering potentially attractive yields in the range of 6-7-8 percent.
Compared to cash and Treasury bonds, corporate bonds offer potentially higher returns, but also carry greater default risk.
Corporate bonds are a more appealing option when interest rates drop, as they continue to provide higher yields compared to options like high-yield savings accounts or cash, but with relatively low risk. While Treasuries might be considered the lowest risk investment, providing unattractive long-term returns, corporate bonds come with more risk yet a higher potential for returns.
Corporate bond returns come from both the regular interest payments and potential price appreciation as interest rates decline.
Nofzinger explains that there are two components to bond returns: regular interest payments and the price appreciation when interest rates decline. As interest rates drop, bond prices generally go up, which can lead to an increase in the total return on the bond. This price appreciation makes the bond more valuable because it offers a higher interest rate than what's currently available.
Conversely, if interest rates rise, the price of the bond decreases since new bonds are being issued at higher rates which makes the ex ...
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Comparing corporate bonds to other investment options
Additional Materials
Clarifications
- When interest rates rise, bond prices typically fall because new bonds offer higher yields. Conversely, when interest rates drop, bond prices tend to rise as existing bonds with higher interest rates become more valuable. This inverse relationship between interest rates and bond prices is a fundamental concept in bond investing.
- When interest rates drop, bond prices generally rise because existing bonds with higher interest rates become more valuable. This price appreciation occurs because investors are willing to pay more for bonds that offer higher interest compared to new bonds issued at lower rates. Conversely, if interest rates rise, bond prices tend to decrease as existing bonds with lower rates become less attractive.
- Bond ETFs (Exchange-Traded Funds) are investment funds that pool money from multiple investors to buy a diversified portfolio of bonds. They trade on stock exchanges like individual s ...
Counterarguments
- Corporate bonds, while lower risk than equities, still carry significant risk, especially in the case of high-yield (junk) bonds, which can default.
- The potential higher returns of corporate bonds compared to cash and Treasury bonds come with increased credit risk, interest rate risk, and the possibility of liquidity risk.
- When interest rates drop, existing bonds may offer higher yields, but new bonds will have lower interest rates, which could be disadvantageous for reinvestment after bonds mature.
- The price appreciation of bonds when interest rates decline is not guaranteed; if the market expects rates to rise, bond prices can decrease, leading to capital losses.
- Investing in corporate bonds through ETFs introduces management fees and other costs, which can reduce the overall return compared to direct bond ownership.
- Corporate bonds may not be suitable for all investors looking to moderate risk, especially if they require liquidity or are averse to the complexities of bond investing.
- The yields on corporate bonds may not keep pace with inflation, which can erode the real purchasing power of the income they generate.
- Selling bonds before maturity can result in c ...
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1-Page Summary- Corporate bonds: definition, purpose, and differences from other bond types
- Corporate bond credit ratings and yields: how they work and the risk/return tradeoff
- Factors to evaluate when investing in corporate bonds (maturity, callability, secured vs. unsecured)
- Comparing corporate bonds to other investment options
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