Why Invest in Corporate Bonds? - dummies

By Russell Wild

To put it bluntly, corporate bonds can be something of a pain in the pants, especially when compared to Treasury bonds. Here’s what you need to worry about when investing in corporate bonds:

  • The solidity of the company issuing the bond: If the company goes down, you may lose some or all of your money. Even if the company doesn’t go down but merely limps, you can lose money.

  • Callability: There’s a chance that the issuing company may call in your bond and spit your money back in your face at some terribly inopportune moment (such as when prevailing interest rates have just taken a tumble).

  • Liquidity: Will someone be there to offer you a fair price if and when you need to sell? Will selling the bond require paying some broker a big, fat markup?

  • Economic upheaval: In tough economic times, when many companies are closing their doors (and the stocks in your portfolio are plummeting), your bonds may decide to join in the unhappy nosedive, en masse. There go your hopes for an easy, sleep-in-late retirement.

Advantages and disadvantages of corporate bonds

Ah . . . that is a question that some of the world’s most prominent investment experts have also asked, and they don’t all come up with the same answer. Some argue that corporate bonds are indeed worth all the hassle and doubt because the higher rates of interest they pay make them preferable to Treasuries.

Others argue that the difference in interest rates between corporate bonds and Treasuries (known as the spread) isn’t worth the potential trouble of holding corporates.

Consider historical returns

It’s hard to argue with this logic: During worst-case scenarios, people do flock to safety. However, if you look at some of the worst economic times in our nation’s history, corporate investment-grade (high quality) bonds have held up remarkably well.

According to data from Ibbotson Associates, a Morningstar company, during the gloomiest economic days of September 1929 through June 1932, long-term corporate bonds showed a total annualized return of 2.99 percent a year, versus 4.84 percent for long-term Treasuries. During the more recent bear market of September 2000 through September 2002, long-term corporates surprisingly outperformed Treasuries, 15.08 percent versus 12.81 percent.

In the big market swoon of 2008, however, Treasuries reigned supreme — although corporate bonds, or at least most corporate bonds, did okay. Long-term Treasury bonds that year returned nearly 26 percent, while corporate bonds overall returned 9 percent. High-yield (junk) corporate bonds, however, got pretty seriously hammered (although they didn’t take quite the same hit as stocks).

Generally, corporate bonds tend to outperform Treasuries when the economy is good and underperform when the economy lags.

Over the long run, corporate bonds outdistance Treasuries by a solid margin. According to Barclays Capital data, corporate investment-grade bonds of all maturities and durations have collectively outperformed their counterpart Treasury issues in 20 of the past 30 years.

[Credit: Illustration courtesy of Vanguard based on data from Barclays Capital]
Credit: Illustration courtesy of Vanguard based on data from Barclays Capital

Since 1982, the overall annualized real return on Treasuries has been about 8.6 percent. The overall annualized return on corporate investment-grade bonds has been roughly 9.7 percent. A basket of corporate bonds invested over the past 30 years would now be worth roughly one-third more than a basket of Treasury bonds.