Your guide to understanding corporate bonds

Most of us know basically how the stock market works vs. the corporate bond market. For a truly balanced investment portfolio, understanding the latter is key. Here's an overview.

Investors usually have some working knowledge of the stock market vs. the corporate bond market. However, a basic understanding of the latter – which dwarfs the stock market – is vital to holding a balanced portfolio.

Why is that?

Because diversification is essential.

Simply put, diversification spreads your money – and risk – around.

• Instead of putting all your eggs in one basket, you'll want to invest in a combination of stocks and bonds, and also keep some money in cash to capitalize on bargains that might pop up.
• Investors are generally more familiar with government bonds. For greater yield in return for higher risk, they should also take a look at corporate bonds.

Companies need to raise capital from time to time. They can go to private sources, float additional shares if they are a public company – or go to the bond market.

• Corporate bonds have maturities, just like their government counterparts, and can run anywhere from one year to 30 years, and in some extreme cases, even longer.

Corporate bonds usually provide a higher yield than Government of Canada bonds.

• You could expect somewhere in the neighbourhood of 0.7% to 0.8% for investment grade bonds, perhaps even as high as 1%.

Be aware that corporate bonds come with an added element of risk:

• While your Government of Canada bond is perfectly safe and you will be paid for owning it, a company can get into financial difficulty leading to a windup of the business. In that event, the value of your corporate bond may wind up being severely depressed.

Bonds can be tricky in a rising interest rate environment.

• If you’ve bought long-term bonds, then the longer the term, the more price impact you have if interest rates start to rise.
• Prices for corporate bonds can also be negatively affected by a deteriorating economic climate, since tough times impact the revenue and profit picture of companies.

It’s certainly not as straightforward as buying stocks. It is vital to have an investment advisor who knows the bond market. Many don’t – the advisor at the bank branch down the street may only have expertise limited to mutual funds.

• You'll need an advisor that will know about a promising new issue. She or he will also need access to those bonds: oftentimes, a large financial institution will scoop up the lion’s share of a new corporate bond issue and make them available to their own clients, leaving other retail investors out of luck.

Consider buying an actively-managed bond fund that invests in corporate bonds.

• Bond market professionals advise staying way from an Exchange Traded Fund (ETF) or an index fund. What's more, if you’re worried about rising interest rates, stick to a short-term fund.

Smart Tip provided by The Financial Pipeline. Founded in 1996 by a group of portfolio managers, The Financial Pipeline is dedicated to providing financial knowledge and education to anyone and everyone with even a passing interest in finance. Our motto, “Financial Information For the Rest of Us,” speaks for itself.