What to Consider Before Investing in Corporate Bonds

(MoneyWatch) 
On Wednesday, we looked at the returns of corporate bonds and compared them with long-term Treasuries. Today, we'll look at other factors you should be aware of before investing in corporate bonds.

Taxes Interest on U.S. government obligations is exempt from state and local taxes. Interest on corporate bonds isn't. Thus, if you have a state income tax, you need different yields from Treasury bonds and corporate bonds of the same maturity -- the corporate yield would have to be higher.

This is why part of the higher yield investors require on corporate bonds over Treasury bonds is related to the difference in tax treatment. The other reasons for the higher required yield are credit risk, liquidity risk and call risk. (Many corporate bonds provide the issuer with the ability to redeem the bond prior to maturity.) Unfortunately, it looks like investors haven't been adequately compensated for taking these risks over the past 85 years. And the main reason may be the call risk. Martin Fridson's study, "Original Issue High-Yield Bonds," found call risk to be a negative contributor to the return on high-yield bonds.

Diversification Because Treasury securities entail no credit risk, there's no need for diversification. Thus, you don't need a mutual fund. Instead, you can buy Treasury securities directly, saving the expense of a mutual fund. Even Vanguard's Short-Term Investment-Grade Fund (VFSTX) costs 0.26 percent. Other corporate bond funds can cost far more. Also, the market for Treasuries is the most liquid and transparent in the world, keeping trading costs down if you want to buy securities yourself or have an investment advisor firm do that. And you can even buy Treasuries at auctions, getting the same price as institutional investors.

However, as we move beyond Treasuries, the need for diversification increases in direct relationship to the credit rating -- the lower the rating, the greater the need for diversification.

The historical evidence suggests you may be best served by excluding corporate bonds from your portfolio, using Treasuries and municipal bonds as appropriate -- given their marginal tax rate.

If you need or desire more return from your portfolio, the evidence suggests that you should consider taking that risk with equities, not with corporate bonds or by adding credit risk. However, if you're going to invest in corporates, the evidence suggests that you should stick with the highest investment grade bonds (as their risks mix better with the risks of equities) and avoid bonds that are callable.