If you're looking for a way to improve on certificate of deposit returns without taking on significant risk, a laddered portfolio of high-quality corporate bonds may provide an advantage.
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 the 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.
Do-it-yourself corporate bonds
InterNotes are primary issue, investment-grade corporate and government agency bonds made available only to individual investors. Each bond sells at par, $1,000, 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 five business days. You can buy them through most brokerages.
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.
"Prior to InterNotes, it was very difficult for individual investors to buy individual corporate bonds," says Tom Ricketts, CEO at 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 InterNotes included a GE Capital bond with a yield of 5.25 percent, and a Bank of America bond yielding 5.25 percent. Some bonds are callable, meaning the issuer could decide to take back the bond and pay you off before the maturity date.
Other companies offering securities through InterNotes include HSBC Finance Corp., Prudential and Dow.
Spreading the risk
When laddering these bonds, you can diversify and spread your risk by buying bonds in different industries with differing maturities, yields and credit ratings, although all are investment grade. But there is a caution.
"As a general rule, we don't like laddering callable bonds," says a Fidelity spokesman.
"You need to be very careful when interest rates are low because that's when the typical call will be made and that's when you most need to keep the bond you have because you can't replace it with a similar rate."
For example, if you buy a bond with a 5-percent yield and a year from now similar bonds are yielding 4 percent, the issuer may decide to call your bond so they can reissue it on the secondary market at 4 percent. Bonds are less likely to be called in a rising rate environment because the issuer would have to pay a higher yield.
Ricketts says about 50 percent of InterNotes bonds are callable.
Of course, 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.
Typically, you could build a ladder with bonds maturing every couple of years, stretching out, perhaps, to 10 years. When the two-year bond matures, the 10-year bond is then due in eight years, so you buy a new 10-year bond with the proceeds from the matured two-year. 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 until maturity, but there is an embedded sales charge that's already been taken out of the interest rate.
You should plan to hold these bonds until maturity. 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 Bank of America bonds, for instance, are selling for at that particular time and at what yield.
If you were buying on the secondary market, you might have to pay a premium if the bond's yield was 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, 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 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 at par without waiting for them to mature.
Unlike CDs, corporate and government agency bonds are not FDIC-insured.