Investment and Non-Investment Grade Corporates |
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The second concept that is important to understand when dealing with corporate bonds is that of credit quality. As discussed in Risk from A to D, corporate bonds tend to be categorized as either investment grade or non-investment grade. Non-investment grade bonds are also referred to as "high yield" bonds because they tend to pay higher yields than Treasuries and investment-grade corporate bonds. However, with this higher yield comes a higher level of risk. High yield bonds also go by another name: junk bonds.
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Junk Bond Caution Investing in below investment-grade (high yield) debt is risky: There is a real risk of default by non-investment-grade companies. Some 10% of junk bonds defaulted during the 2001 recession; the default rate in 1990, another recession year, hovered just under 8%. For this reason, diversification is considered vital in junk bond investing.
The cost of buying and selling junk bonds also can be high. If you invest in high yield bond funds, be advised that expenses associated with these funds can be steep, as mutual funds pass on the cost of buying and selling to the investor.
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Some corporate bonds are more liquid than others. Credit rating, yield and a host of other factors play on supply and demand. While you may not have trouble finding a buyer for the bond of a giant company, the ability to find a buyer for a low-grade, infrequently traded bond issued by a small company that few have heard about may be quite difficult (reflected in a much wider bid-ask spread). For more information, see Buying and Selling Corporate and Municipal Bonds.
Guaranteed and Insured Bonds
Certain bonds may be referred to as guaranteed or insured. This means that a third party has agreed to make the bond's interest and principal payments, when due, if the issuer is unable to make these payments. You should keep in mind that such guarantees are only as valuable as the creditworthiness of the third-party making the guarantee or providing the insurance.
Convertibles
Convertible bonds offer holders the income of regular bonds and also an option to convert into shares of common stock of the same issuer at a pre-established price, even if the market price of the stock is higher. Convertible bond prices are influenced most by the current price—and the perceived prospects of the future price—of the underlying stock into which they are convertible. As a tradeoff for this conversion privilege, convertible bonds typically yield less.
| Smart Idea. You should be careful to understand the conditions under which the bonds may be converted as this right is often contingent upon, among other things, the issuer's stock reaching a certain price level. You also should ask your broker or financial adviser whether there is any charge or fee associated with making a conversion. |
Also see Buying and Selling Corporate and Municipal Bonds.
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