Use corporate bonds to build your investment ladder

What is a corporate bond?

A corporate bond is a form of debt security -- essentially an IOU -- issued by public and private companies to investors. The money raised may be used to pay for acquisitions, debt refinancing, capital improvements and more. Unlike stocks, bonds do not offer investors any stake in the company. Corporate bonds are essentially loans repaid at a set interest rate and on a set schedule.

If you want to improve on certificate of deposit returns without taking on significant risk, consider investing in a laddered portfolio of high-quality corporate bonds.

The world of corporate bonds can be a bit intimidating to smaller do-it-yourself investors. If you're not well-versed in areas such as primary issues, the secondary market, credit quality risk, and buying at par, discount or premium, you may be tempted to stick with more plain vanilla investment options.

But there is a way to buy corporate bonds that makes bond selection and purchase much easier. It also enables you to simply create a diversified ladder that employs a variety of criteria. It's called InterNotes.

Do-it-yourself corporate bonds

InterNotes are primary issue, investment-grade corporate bonds made available only to individual investors. Each bond sells at par, $1,000, which is the minimum investment, and they can be purchased in increments of $1,000. The bonds are issued weekly and are typically available for purchase for 5 business days. You can buy them through most brokerages.

Colleagues shaking hand at meeting | Caiaimage/Sam Edwards/Getty Images

Unlike bonds on the open market, which often have far higher purchase minimums and yields that fluctuate constantly, you don't have to make a quick decision about whether to buy corporate bonds through InterNotes.

"Prior to InterNotes, it was very difficult for individual investors to buy individual corporate bonds," says Tom Ricketts, chairman of Chicago-based Incapital, the co-agent for InterNotes.

"This simplifies and slows down the whole process for individual investors. They can understand what they're buying and have time to make an informed decision because the issuers accommodate the individual investor by holding the rate firm from Monday through the following Monday."

A recent offering of investment grade bonds on InterNotes included a Discover Financial Services bond with a yield of 3.85% and a Prospect Capital Corporation bond yielding 5.5%.

Other companies offering securities through InterNotes include Goldman Sachs, Ford Motor Credit Co. and Deutsche Bank.

Spreading the risk

When laddering investment-grade bonds, you can diversify and spread your risk by buying bonds in different industries with differing maturities, yields and credit ratings. However, some corporate bonds are callable, meaning the issuer could decide to take back the bond and pay you off before the maturity date.

Investing in callable bonds therefore requires some caution because the best-laid plans can be derailed if a bond is called.

For example, if you buy a bond with a 5% yield and a year from now similar bonds are yielding 4%, the issuer may decide to call your bond so it can reissue the bond on the secondary market at 4%, reducing your earnings and requiring a new investment or laddering strategy. In a rising rate environment, bonds are less likely to be called because the issuer would have to pay a higher yield.

Ricketts says about 50% of InterNotes bonds are callable.

The advantage is that you're paid a higher yield for taking on the risk of a callable bond. If that higher yield is appealing to you, sprinkle your ladder with a few callable bonds, but keep the majority noncallable to offset the risk.

Laddering corporate bonds to maximize returns

Typically, you build a ladder using corporate bonds that mature every couple of years, stretching out, perhaps, to 10 years. When the 2-year bond matures, the 10-year bond is then due in 8 years, so you buy a new 10-year bond with the proceeds from the matured 2-year bond. You're always buying the longest bond and reaping the rewards of the higher yield.

You won't pay an obvious fee for buying or selling one of these bonds if you hold them until maturity, but there is an embedded sales charge that's already been taken out of the interest rate.

This is one reason you should plan to hold these bonds until maturity. Further, while a broker may be able to sell your bond on the secondary market, there is limited liquidity, according to Ricketts.

"It's not liquid like the Treasury market. There's not the huge liquidity that you find on a very large corporate issue or government issues. These aren't trading vehicles."

Because of the way InterNotes are sold, it can be difficult to tell if you're getting the best deal. You could see what other Deutsche Bank bonds, for instance, are selling for and at what yield.

If you were buying on the secondary market, you might have to pay a premium if the bond's yield were higher than the current yield. Similarly, you could be missing out on buying a bond at a discount if the bond's yield were lower than prevailing yields. You could also find yourself liable for paying accrued interest to the seller.

"If you had a good broker, you might be able to do better," Ricketts says. "But if you're buying just $10,000, nobody gives you a good price. The process is not built for the individual."

Before buying these corporate bonds, you might want to check to see what Treasuries with similar maturities are yielding. You'll want to make sure you get a higher yield to account for the added risk of a possible default by a corporation.

Buying individual bonds in this fashion can beat the return you'll get with a bond fund. You sacrifice the bond fund's liquidity, but avoid the load and ongoing fees bond funds often carry. If you hold the individual bond until maturity, you'll also avoid the potential risk of loss of principal that comes with bond funds.

An interesting feature of InterNotes is the survivor benefit, which allows your heirs to return the bonds to the issuer without waiting for them to mature.

Unlike CDs, corporate bonds are not FDIC-insured.


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