Corporate Bonds

As of 2006, the size of the outstanding U.S. bond market debt was $25.2 trillion. Nearly all of the $923 billion average daily trading volume (as of early 2007) in the U.S. bond market takes place between broker-dealers and large institutions in a decentralized, over-the-counter (OTC) market. The New York Stock Exchange (NYSE) is the largest centralized bond market, representing mostly corporate bonds.

For market participants who own a bond, collect the coupon and hold it to maturity, market volatility is irrelevant; principal and interest are received according to a pre-determined schedule. But participants who buy and sell bonds before maturity are exposed to many risks, most importantly changes in interest rates. When interest rates increase, the value of existing bonds fall, since new issues pay a higher yield. When interest rates decrease, the value of existing bonds rise, since new issues pay a lower yield. Fluctuating interest rates are part of a country's monetary policy and bond market volatility is a response to expected monetary policy and economic changes.

Compared to government bonds, corporate bonds generally have a higher risk of default. This risk depends, of course, upon the particular corporation issuing the bond, the current market conditions and governments to which the bond issuer is being compared and the rating of the company. Corporate bond holders are compensated for this risk by receiving a higher yield than government bonds.

Key Point #1: Companies, such as Moody's and Standard and Poors, rate the risk of the bond. Companies with top ratings of A or better are called investment grade and those rated lower are called junk grade. Junk bonds have more risk and compensate the investor by paying a higher rate. The difference above the investment grade bond is called a spread. Conservative investors will choose to invest in primarily investment grade bonds or a mutual fund that invests primarily in investment grade bonds.

Key Point #2: You can make money by holding the bond to maturity and getting the interest that is paid every 6 months called the coupon payment. You can make money by buying and selling bonds and getting a capital gain on the face value of the bond.

Key Point #3: Normally, when interest rates go up the coupon payment stays constant, and the face value of the bond goes down and vice versa. Another factor, key point #4, is the risk of default can also drop the face value of the bond. Interest rate changes are more important for bonds that have a long time to maturity and less important for a shorter term duration. You can mitigate this risk by selecting short term bonds or mutual funds that invest in short term bonds.

Key Point #4: Bond holders have a risk of not getting paid full value. For example owners of GM bonds got paid about half of the face value. When the economy enters a recession and companies can go out of business the face value drops and the drop can be much larger than the gain from the dropping interest rate. This is what happened in 2008 and early 2009 and why virtually every corporate bond dropped in value.

Key Point #5: An investor needs to know where we are in the Business Cycle when investing.

Bottom Line: Given where we are in the Business Cycle, we have much less risk of a default. Face values that dropped last year should be recovered or recovering. Interest rates are rising so staying on the short time duration to maturity makes sense. A conservative investor should pursue a mutual fund with primarily investment grade bonds while a more aggressive investor should pursue a mutual fund with primarily junk bonds.