Corporate bonds offer investors the opportunity to participate in the debt securities of established companies, providing a fixed income stream over a specified period. However, although they generally have higher returns than government bonds, investing in corporate bonds entails inherent risks that demand careful consideration.
A hypothetical scenario: StableCo and MatureCo
Consider two hypothetical companies: StableCo, a stable, mature company with no debt, and MatureCo, a similar entity valued at $1 billion. StableCo delivers consistent growth, aligned with the economy at 4% annually, and offers a 3% dividend yield, summing up to an expected return of 7%.
MatureCo opts to borrow $500 million in debt at a 5% interest rate, using the proceeds to distribute a $500 million dividend to shareholders. Consequently, the company's total stock value stands at $500 million, with $500 million in debt, for a total valuation of $1 billion. Due to this debt, MatureCo's expected return is higher, 9%. When you average the 9% equity return with the 5% bond return, you get a return of 7% on the total business, matching StableCo.
Market Turbulence and Risk Exposure
Amid a recessionary downturn affecting StableCo and MatureCo alike, both companies witness a 25% decline in business value, from $1 billion to $750 million. StableCo's stock undergoes a 25% drop, whereas MatureCo still has $500 million in debt, so its equity is worth $750 million - $500 million = $250 million, for a drop of 50%. Thus, MatureCo's debt increases its expected return while magnifying its vulnerability to market downturns.
The company's debt takes on some of the risks of the company, but much less, since it has the shareholder's value as a buffer. So, when you buy corporate bonds, you take on the same types of risks as a stock market investor (but less).
Suppose you have a portfolio, 50% government bonds yielding 4%, and 50% stocks expected to return 8% (the actual future return for stocks is always unknown). If you sell some of your government bonds to buy corporate bonds yielding 5.5%, you would earn more on bonds. But you would need to sell some stocks if you wish to keep the risk of your portfolio the same, reducing the potential benefit of the expected return. Furthermore, bonds can default, leading their expected return to be lower than their yield.
A typical asset-allocation recommendation is to put your bond allocation into an investment-grade (low default risk) bond fund/ETF, Such as the aggregate bond fund. Then, you are buying bonds in an allocation that represents the overall market. Typically, corporate bonds are approximately 25% of this. Other investors prefer to invest their fixed-income exclusively in government bonds, only taking corporate risk on the equity side. The returns of both strategies are likely to be similar.
Conclusion
A diversified portfolio requires balancing returns with the associated risks. While opting for corporate bonds may amplify bond-related returns, it necessitates adjustments in equity exposure to maintain risk equilibrium. Moreover, investors must remain cognizant of default risks inherent in corporate bonds, which are related to the same economic risks that impact the stock market.