What are the benefits of corporate bonds?

In normal times, corporate bonds are the also-rans of the asset class world. They’re sometimes sexed-up, such as in the 1980s when Wall Street raiders used junk bonds to fuel company takeovers. But usually they’re too boring to interest private investors.

Boring can be profitable, but only if the underlying risk/return case is good. In my personal view, that’s rarely true of corporate bonds. (Many financial advisors and writers think different).

Corporate bonds:

• Offer none of the income growth of equities
• Are still exposed to the risk of company failure
• Don’t adequately diversify the risk of holding equities
• Aren’t anything like as secure as government bonds (governments can print money to pay their debts)
• Yield only 0.5-1.5% more than government bonds (in normal times!)

But what if the times aren’t normal?

Interesting times for corporate bonds

In a typical snippet arguing for corporate bonds in The Telegraph, one analyst reflected the views of many in 2008:

“We believe investment grade corporate bonds are especially attractive, with current spreads higher than when Bear Stearns was bailed out in March and higher than during the dotcom crash of 2001.”

Extreme risk aversion followed the 2007-08 financial crisis, leaving corporate bonds looking unusually priced versus government bonds, as The Independent noted:

The prices of corporate bonds have sunk so low as to suggest that one in three investment grade companies will go bust over the next five years – the kind of scenario which has not been seen since the Great Depression.

Bloomberg reported US corporate bond sales boomed in early 2009 as investors bought into the story:

U.S. corporate bond sales soared to $41 billion this week, the most in almost eight months, as companies took advantage of investor demand to raise cash in a weakening economy.

As ever, the incentive was extra income, says Reuters:

At the heart of the trade, investors have concluded that it’s finally safe to wander from the safety of U.S. government debt, which hit record low yields in December and still hang below 1 percent for two-year maturities.

I wrote in late 2008 that government bonds were in a bubble. But what are the benefits of corporate bonds as an alternative? Do they make up for the risk?

Exploring the case for corporate bonds

I’ll be writing several articles on corporate bonds as I explore these issues. This post is the first in that series: Investing in Corporate Bonds.

To cut to the chase, I think if you’re ever going to add corporate bonds to your portfolio, circumstances such as those following a panicked credit crisis may offer a window. The extreme fear in the market creates imperfect pricing, and so opportunities for the brave.

Generally I agree with David Swensen, the famous Yale portfolio manager. In his book Unconventional Success (U.S. link), Swensen demolishes the argument for private investors putting their money into corporate bonds, concluding:

Many investors purchase corporate bonds, hoping to get something for nothing by earning an incremental yield over that available from U.S. Treasury bonds. If investors received a sufficient premium above the default-free U.S. Treasury rate to compensate for credit risk, illiquidity, and callability, then corporate bonds might earn a place in investor portfolios.

Unfortunately, under normal circumstances investors receive scant compensation for the disadvantages of corporate debt.

However speaking to Bloomberg in January 2009, Swensen, the arch-nemesis of corporate bonds, admitted they currently looked attractive:

In the current environment, distressed corporate securities can produce “equity-like” returns, Swensen said.

“You want to make sure you’re with companies that have the ability to survive in a really tough economic environment” he said, declining to name any of the companies.

To me that’s a signal to look again at adding corporate bonds at current prices to my portfolio.

Over the next few articles I’ll consider the different types of corporate bonds, the risks and rewards of holding them, compare them with the benefits of holding stocks, and explore how to actually make an investment.

As Swensen says:

“Casual attempts to beat the market provide fodder for organizations willing to devote the resources necessary to win… Nobody said this was easy. You’ve go to do an enormous amount of work to get it right.”

Prepared to put the work into understanding corporate bonds? Then subscribe (for free) to Monevator to get all the articles in this series.