Must-know drivers for investing in corporate debt ETFs

Market Realist

Must-know: Analyzing the latest corporate debt investments (Part 1 of 5)

Corporate debt

Corporate debt includes bonds issued and loans raised by a corporation to raise money effectively in order to expand their businesses through organic as well as inorganic modes or to increase management control through buy-back of shares. It usually includes longer-term debt instruments, generally with a maturity date falling at least a year after the issue date. The additional credit risk to the investor is what primarily differentiates corporate debt from government debt.

Premium for risk

Compared to government debt, corporate debt generally has a higher risk of default. This risk depends on the financial health of the particular corporation issuing the debt security, its ability to timely service its debts, and current market conditions. Corporate debt holders are compensated for this risk by receiving a higher yield than government bonds. The difference in yield reflects the higher probability of default plus the expected loss in the event of default, and it may also reflect liquidity and risk premium.

Risks in corporate debt

Investing in corporate debt entails taking on various risks in the form of default risk, credit spread risk, interest rate risk, liquidity risk, supply risk, inflation risk, and tax change risk. Default risk and credit spread risk are also the two main factors investors consider while investing in corporate debt.

Default risk: The possibility that an issuer will default by failing to repay principal or interest in a timely manner. Bonds issued by the Federal government, for the most part, are immune to default (if the government needs money, it can just print more). Bonds issued by corporations are more likely to be defaulted on, since companies may go bankrupt.

Credit spread risk: Credit spread is the extra yield to compensate investors for taking default risk. Credit spread risk is the risk that the credit spread of a debt security, which is either inherent in the fixed coupon or paid at a fixed rate above the risk-free rate in the case of a floating interest rate, becomes insufficient to compensate for the default risk that has later deteriorated.

Investing in corporate debt

There are various exchange-traded funds that invest in corporate debt. Popular examples are the iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD), which invests in bonds issued by investment-grade corporations like Verizon Communications (VZ) and Bank of America Merrill Lynch (BAC), as well as the iShares iBoxx $ High Yield Corporate Bond Fund (HYG) in the corporate bond market category, and the PowerShares Senior Loan Portfolio (BKLN) and Highland/iBoxx Senior Loan ETF in the corporate loan market category.

The corporate bond segment is further divided into the investment-grade segment and non–investment-grade debt. The non–investment-grade component comprises the high-yield or junk bonds segment and the leveraged loans segment. Read on to the next part of this series to find out the key differences in meaning and fund flows between these segments.

Continue to Part 2

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