What Are the Risks Associated With Owning a Corporate Bond?
There are several ways that a corporation attempts to raise funds to offset operating expenses. One way an investor can get in on the action is through bonds. A bond is a form of loan to the corporation in which the investor expects to get paid back with interest.
Corporate bonds promise a high rate of return on an investment compared with some other types of bonds, but there are some risks.
Interest Rates and Inflation
Interest rates are tied to rate of return on the bond investment. Bond prices fall as interest rates rise. The bond prices increase when interest rates are lower. The price you pay for the corporate bond and the interest rate associated with the bond determines the performance.
The purchase power of the dollar also impacts the cash flow from the bond, bringing inflation into play. The investor’s cash flow is the periodic coupon payments and the payments received at the maturity of the bond. Inflation also can bring interest rates higher, hurting bond prices.
Corporate bonds, similar to loans, can be refinanced. To exercise this option, a corporation sells the bonds with a call option.
The call option allows the corporation to call the bond in and re-issue new bonds to the investors at lower interest rates. Ruth Anne Mears, professor at Ohio State, says the you “run the risk of having to reinvest your money at lower interest rates.”
Companies can downsize and buy other companies at any time. These types of changes in the corporation are called “events.”
Anything that increases the company’s debt will impact the corporation’s ability to pay back their bonds. These events can be negative for an investor, threatening an investment.
The longer an investor holds a corporate bond, the worse his chances of getting his investment back with interest, as there is a longer period of time for market and economic factors to go south and reduce the rate of return on the investment.
In an January 2019 edition of Smart Money Magazine, Elizabeth O’Brien wrote that “it’s usually best to stick to maturities of 10 years or less.”
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