Are Corporate Bonds Worth a Look?

April 23, 2013

In this age of low returns on certificates of deposit and jitters over the stock market, many investors wonder where to put their money. One option is corporate bonds. Corporations issue bonds to finance expansion or acquisition of other firms. According to the Securities Industry and Financial Markets Association, the value of U.S. corporate bonds issued was $1.36 trillion in 2012, says Pamela Villarreal, a senior fellow at the National Center for Policy Analysis.

  • Corporate bonds carry a much greater risk of default than U.S. government bonds, and when issued by firms with poor credit ratings, they are called "junk bonds."
  • Treasury bonds are backed by the full faith and credit of the United States government, whereas corporate bonds rely on a firm's ability to pay back bondholders.

Corporations typically issue bonds for periods ranging from one year to 30 years. As with stocks, bonds are traded on the open market. Whether sold by a firm or the government, bonds usually pay a fixed rate of interest (also referred to as coupon payment) quarterly, semi-annually or annually until maturity. When the bond matures, the issuer pays the principal amount to the purchasers. In the interim, however, a bond purchaser can sell the bond to anyone in the so-called secondary market.

Bond defaults in the United States have been characterized by periods of low and highs that do not necessarily correlate with economic growth or the business cycle. A study by Kay Giesecke of Stanford University and her colleagues found:

  • The largest default occurred from 1866 to 1899, when on average 4 percent of the value of bonds issued defaulted each year.
  • From 1900 to 1945, average annual defaults fell to 1.3 percent.
  • Post-World War II, from 1946 to 2008, the average annual default rate fell to its lowest level at 0.30 percent of all bonds issued.

Even during the junk bond scandal of 1990, only 1.5 percent of junk bonds defaulted. Since then the largest corporate bond default period took place during the dot.com crisis from 2001 to 2002, when an average of 2.5 percent of bonds defaulted.

How have corporate bonds performed relative to other investments? Consider:

  • In 2008, the returns on the corporate bond funds were negative, ranging from -11.8 percent to -36.1 percent, while the longer-term Treasury bond fund yielded 10.2 percent.
  • In 2009, however, the corporate bond funds rebounded substantially, with yields ranging from 31.6 percent to 74.8 percent, while the Treasury bond fund fell into negative territory (-2.5 percent).
  • In 2012, the Treasury bond fund returned 0 percent for the year, while the corporate bond fund experienced double-digit gains.

Investors, particularly retirees, looking for decent returns but who are reluctant to buy stocks may want to consider corporate bond funds.

Source: Pamela Villarreal, "Are Corporate Bonds Worth a Look?" National Center for Policy Analysis, April 23, 2012.

 

Browse more articles on Economic Issues