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How to Invest in Corporate Bonds

Lou Carlozo

There's a certain swagger that goes with saying you own stocks. The label "shareholder" conjures some combination of savvy gambler and calculated risk taker. You own a piece of the action and if a company hits the jackpot, you get to brag; if it tanks, you can always whistle and change the subject to "Game of Thrones" reruns.

Company bondholders, by contrast, get no such bragging rights. In fact, many investors who love stocks couldn't tell you the difference between a company bond, a bail bond and those U.S. Savings Bonds Aunt Winnie used to dole out with boxes of marzipan candy.

Yet the smart investor won't want to overlook this potential income source, as company or corporate bonds provide a stabilizing element to many portfolios -- especially those weighted towards aggressive holdings.

[See: 10 of the Best Stocks to Buy for 2019.]

So what's the difference between owning company stocks and bonds? That comes down to whether you'd rather be an owner or a lender. Stock entitles you to a stake in the company and its dividends, while a bond puts you in the equivalent role of a banker financing the operation. Some investors prefer bonds because they come with a guaranteed yield (also known as the coupon rate) and the return of the principal.

"Like with any bond, a corporate bond is simply a financial security recognizing that investor is loaning money to a corporation," says Robert Johnson, a finance professor at Creighton University's Heider School of Business. "A bondholder can only receive what is promised -- nothing more."

Stocks of course come with no such guarantee, though they do dangle the prospect of handsome returns should share prices take off: something bond investors can only witness from a wistful distance.

"That's why bonds are often referred to as fixed income securities," Johnson says. "If everything goes as planned, a bondholder knows exactly what she will receive and the return she'll earn if she holds the bond to maturity. If you bought a bond of a wildly successful company -- like Microsoft Corp. (ticker: MSFT) or Apple ( AAPL) -- and you held to maturity, the best you could hope for is to receive the promised interest payments and the full return of the principal amount."

Three ratings agencies assign grades to company bonds, with AAA or Aaa being the highest, also known as "prime." "Corporate bonds offer a decent source of income as part of a diversified portfolio," says Andrew M. Aran, partner at Regency Wealth Management in Ramsey, New Jersey. "They offer a higher yield than Treasury bonds with modestly higher risks for the investment-grade variety -- those with rates BBB or higher."

But if the fears of some economists pan out and the U.S. enters a recession, the BBB border line could become shorthand for Big Bad Bear crossing.

"We also see a risk with bonds rated in the BBB area, which is the lowest rung of investment grade," says Collin Martin, managing director and fixed income strategist at Schwab Center for Financial Research. "During a recession, there's a greater risk that some of these corporate bonds could be downgraded by the major rating agencies to junk, which would likely send their prices lower."

[See: 7 Best Corporate Bonds to Buy and Hold for 2019.]

When an investment falls below BBB- (Standard & Poor's, Fitch) or Baa3 (Moody's), it becomes junk as opposed to investment grade. Yet even within junk status, there are four risk tiers before a company hits partial or full default.

True, bonds below investment grade lure with higher yields -- but that doesn't mean they're necessarily worth the risk. Billionaire Warren Buffett has been known to derisively call junk bonds "weeds priced as flowers."

Interestingly, "The issuer's common stock performance can also, at times, provide an early indication of the issuer's stress as ratings tend to lag deteriorating performance," Aran says.

And in some cases, looking at a bond can sometimes tell you more about the true state of a company's affairs than its stock price.

For years, Tesla stock ( TSLA) boasted a skyrocketing price that in no way correlated to its price-to-earnings ratio -- and never could, since Tesla almost never turned a profit. Between June 2012 and 2017, Telsa shares exploded more than 1,000 percent as the company hit an all-time high of $383.45.

But those following the bond side of things would note that in April, Telsa's $1.8 billon junk bond got slammed as the company reported a bigger-than-expected drop in first quarter vehicle deliveries. On Aug. 20, Moody's noted that expanding efficiencies in Model 3 production had stabilized matters somewhat, and upgraded its bond outlook from negative to stable; Tesla stock began this week at $225.61.

Given that corporate bonds represent a narrow slice of the bond pie, experts advise investors to step back and survey the field to determine what works best for their risk tolerance.

"For investors who are very conservative, Treasurys or AAA government bonds and investment-grade municipal bonds are preferred," says Mayra Rodriguez Valladares, managing principal at MRV Associates and a bank regulatory and capital markets consultant based in New York City. "Yet I think any investor should have a diversity of assets including corporate bonds, securitizations and equities."

If the corporate bond route sounds appealing, there are several ways to go.

[See: 10 of the Best Dividend Stocks to Buy for 2019.]

"You can select the corporate bonds you want, yet that can be time consuming and expensive with broker fees," Valladares says. "You can invest in corporate bond mutual funds where often the minimum investment is low, or be exposed to corporate bonds by buying an exchange-traded fund, with which you get transparency and market liquidity."

A wide spectrum of investment grade bonds represent every economic sector, Valladares adds, though one hard-hit area merits a pass for now: "I'd stay from retail, where there have been defaults and downgrades recently."

In other words, don't let any fall clearance sale change your mind.

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