While government bonds provide a means for individual investors to lend to governments, corporate bonds provide a means of lending to large corporations. A corporate bond is issued by a corporation to raise money to fund or expand it’s business. Individuals can loan money to the corporation by purchasing their bonds. In return, the corporation pays the individual interest on the bond, and returns the full value of the bond at a fixed redemption date.
Corporate bonds tend to provide higher interest payments than government bonds due to their higher level of risk. Lending to companies is usually riskier than lending to most developed world governments, as companies are generally believed to be more likely to default. Corporate bonds are thus likely to perform worse than government bonds in bad economic times.
This section refers only to ‘investment grade’ corporate bonds. These are bonds that are issued by companies with strong credit ratings. It does not deal with ‘high income’ or ‘junk’ bonds which, while they pay much higher interest, are far riskier.
Investment grade corporate bonds tend to deliver higher growth than government bonds in normal economic times. Although they are higher risk than government bonds, they are significantly lower risk than equities or property.
Advantages of corporate bonds
Corporate bonds have the following advantages:
- They have higher growth potential than government bonds
- They are less vulnerable to inflation and interest rate increases than government bonds due to generally shorter periods to redemption
- They are a very useful diversifier for low-medium, medium and medium-high risk portfolios
- They are less risky than equities or property
Disadvantages of corporate bonds
Corporate bonds have the following disadvantages:
- They are higher risk than government bonds due to a greater danger of default
- They may fall in value if interest rate or inflation expectations rise
- They may fall in value in the event of a severe economic downturn
- They are unlikely to match long run returns on equities