The corporate bond market is one of the largest markets in the world, worth $9.77 trillion, or nearly 25% of the entire U.S. bond market as of the start of 2014. Corporate bonds are appealing as they are considered safer than stocks and they pay higher interest than government bonds.
Corporate bonds can be divided into two types: investment grade and junk (otherwise known as high yield securities), which is arguably the most important choice when determining a portfolio of corporate bonds. These two types of corporate bonds can be broken down further into short-, medium- or long-term and can be broad-based, domestic, foreign, or sector specific.
Junk bonds, those rated BBB- and lower, have a higher risk of default, but they pay higher yields than investment grade corporate bonds. Regardless of the type, corporate bond mutual funds allow for investors with smaller portfolios to gain exposure to this asset class, and can provide a well-diversified high yield corporate bond portfolio at a low cost.
How Corporate Bond Funds Can Be Used in a Portfolio
Corporate bond funds are a great choice for investors seeking yields higher than government bonds that are still relatively safe. They can be bought and sold using a regular brokerage and give exposure to this particular asset class. As with any investment, there are risks involved. Corporate bond funds have higher expense ratios than a comparable stock mutual fund.
With an individual bond, risk decreases the longer you hold the security, but this is not true with corporate bond funds because the individual holdings are constantly maturing, being bought and sold. There are many different kinds of corporate bond funds with different risk/return profiles that can cater to a variety of different investor appetites.
Types of Corporate Bond Funds
There are a variety of different types of bond funds:
Broad-based: These cover a variety of different corporate bonds, everything from investment grade to junk, domestic and foreign. These are good for investors wanting a little bit of everything that corporate bond funds have to offer.
Domestic: Those originating from an investor’s home country.
Foreign: This includes bonds that are issued and traded outside the country in whose currency they are denominated, and U.S. dollars held by foreign institutions outside the United States. These can include eurobonds and eurodollar bonds.
Sector Specific: As there are many different types of corporations, investors can buy bond funds in corporations in specific sectors, such as energy.
Benefits of Owning Corporate Bonds with Mutual Funds
Corporate bond mutual funds offer diversification to an investor’s portfolio and require a low minimum investment. There are no upfront sales commissions or redemption fees either. It is easier to construct a corporate bond portfolio by purchasing a single mutual fund than it is to do research on the same number of corporate bonds that the mutual fund consists of along with managing the maturity date of different bonds.
Furthermore, bond mutual funds never mature like a single corporate bond would; as corporate bonds mature within the portfolio they are replaced with others. Another benefit is that corporate bond mutual funds give you access to the expertise of a portfolio manager. With these benefits, investors looking to gain exposure to corporate bonds should at least consider a corporate bond mutual fund.
If an investor owns bonds that generate taxable income, then that investor will be taxed on that income in the year it’s received. Since fund managers regularly buy and sell bonds, there may be capital gains involved, in addition to taxation on the interest received. Income from corporate bond funds are generally taxed at the federal and state level at the investor’s ordinary income tax rate; capital gains taxes can be eligible for a reduced capital gains rate. Like other investments, the tax owed on corporate bond funds can be deferred if an investor holds the investment in a retirement account such as a 401(k).
According to U.S. News Ratings, these are some of the largest and most popular corporate bond mutual funds. These funds Investors should do due diligence as each fund caters specifically to a certain market.
BlackRock Allocation Target Shares Series C (BRACX)
This fund seek to maximize total return, investing in corporate bonds, notes and debentures; asset-backed securities; commercial and residential mortgage-backed securities; U.S. Treasuries; and cash equivalent investments.
BMOTCH Corporate Income Fund (MCIIX)
The fund invests at least 80% of its assets in corporate debt securities, including convertible debt securities. Although it will invest primarily in U.S. dollar denominated securities with a minimum rating in the lowest investment grade category at the time of purchase, the fund may invest up to 20% of its assets in debt securities that are below investment grade, also known as high yield securities or “junk bonds,” and non-U.S. dollar denominated foreign debt securities
PIMCO Long-Term Credit Fund (PTCIX)
The fund normally invests at least 80% of its assets in a diversified portfolio of fixed-income Instruments of varying maturities, which may be represented by forwards or derivatives such as options, futures contracts or swap agreements. It invests primarily in investment grade debt securities, but may invest up to 20% of its total assets in junk bonds that are rated B or higher by Moody’s, or equivalently rated by S&P or Fitch, or, if unrated, determined by PIMCO to be of comparable quality.
GuideStone Funds Extended-Duration Bond Fund (GEDYX)
The fund invests mainly (at least 80% of its net assets, plus borrowings for investment purposes, if any, and typically more) in fixed-income securities. It may hold up to 30% of its assets in obligations denominated in currencies other than the U.S. dollar, and may invest beyond this limit when considering U.S. dollar-denominated securities of foreign issuers.
Vanguard Long Term Investment Grade Fund (VWESX)
The fund invests in a variety of high-quality and, to a lesser extent, medium-quality fixed income securities, at least 80% of which will be intermediate- and long-term investment-grade securities. High-quality fixed income securities are those rated the equivalent of A3 or better; medium-quality fixed income securities are those rated the equivalent of Baa1, Baa2, or Baa3.
The Bottom Line
There is no right or wrong when it comes to investing in corporate bond funds. Corporate bond funds make sense for those with smaller investment amounts devoted to their fixed income portfolio or for those seeking convenience of buying and selling a basket of bonds with a single investment. There are so many kinds that there is probably one that suits each kind of investor. Just be sure to do the due diligence before any investment.