How To Tell If a Corporate Bond Is a Good Investment with Sam Nofzinger, GM of Brokerage at Public

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2:53Otherwise, 1.00 % APY applies. No min balance required. Chime card on-time payment history may have a positive impact on your credit score. Results may vary. See chime.com for details and applicable terms. I'm Nicole Lappin, the only financial expert you don't need a dictionary to understand. It's time for some Money Rehab.

3:16Hey, Money Rehabbers. It's Morgan. I'm the executive producer of the show. And I'm going to tell you about what you're going to hear in today's episode. Today, you're going to hear Nicole talk about corporate bonds. And she's talked a lot on the show about government bonds, things like T-bills, inflation-protected treasuries, savings bonds, you know the ones. But there's a whole other world of bonds issued by companies like Apple, Microsoft, NVIDIA, Meta, Alphabet, and as it turns out, a whole lot more. Nicole is going to tell you everything you need to know about bonds, but she's not going to do it alone.

3:48She's joined by Sam Nofsinger today, who is the GM of brokerage at Public. And as you know, because Nicole talks about it a whole lot, Public is Nicole's favorite place to buy bonds, and not just government bonds, but corporate bonds too. Public actually has a bond yield account, which contains corporate bonds, which on the day this episode is airing, the yield is 6.83%, although that is subject to change unless you lock it in. Nicole and Sam talk about why companies issue corporate bonds, how to tell if a bond is investment worthy, and what kinds of returns you can make by investing. And just so you know, you'll hear throughout the episode some background noise, regular city stuff like honking, cars going by, maybe some voices.

4:32Probably like you can hear my puppy in the background of this recording right now. Life has background noise, so it goes. Enjoy the conversation. it.

4:43Sam Nofzinger, welcome to Money Rehab. Thank you so much for having me. Pleasure to be here. So today we're going to do a mini masterclass on corporate bonds. Thank you so much for helping us with this. Obviously, I just need to start with the basics. What is a corporate bond? So a bond just basically is a loan. So similar to how if someone asks you for money and they say, hey, can I borrow a thousand bucks, right? I'll give you back a thousand bucks plus$50 dollars in interest next year. It's kind of the same thing like that, except instead of dealing with your friend or dealing with a family member, you're dealing with a big corporation.

5:16Corporations like Apple or NVIDIA or Microsoft, they offer bonds to the investing public to raise money for different needs that they have. And so investors have the ability to not only purchase stock in these companies and kind of ride the wave on profits, but they can say, hey, you know what, instead of lending money to the bank, instead of lending money to the US government, I trust Apple, I trust NVIDIA. They're paying attractive yields. Let me park some of my money there and actually invest in fixed income as opposed to cash or other things to earn yield. So you mentioned public stocks, NVIDIA, Apple, Microsoft, all of the big ones have corporate bond offerings, smaller ones too.

5:54But can both public and private companies issue bonds or essentially IOUs as you describe them? Yes. Anyone can issue bonds. And it's funny. In the stock market, there's about 10 ,000 stocks that folks can buy and sell. In the bond market, there's over 1.5 million different bonds that people can buy. And a lot of those are smaller private companies. And a lot of those are just companies issuing many bonds over time. So I think it's helpful to step back and understand why companies issue bonds. When we talk about treasuries, which are bonds issued by the government, we talk about this idea that if the government or a state or a municipality wants to do something, build a road or a bridge or something, they'll issue bonds to the public.

6:38And for the privilege of using somebody's money for a certain amount of time, they'll give it back plus interest. Essentially, that's what companies are doing with corporate bonds too. But can you explain why they would want to essentially raise money in this way versus a stock offering? Sure. And the general answer is it's cheaper for the companies to offer bonds as opposed to equities if the company is mature. So Apple can go out and raise a bunch of money in the stock market, but then that dilutes all the owners of Apple and they don't really like that. However, Apple can say, hey, we can raise money through a bond offering, not dilute our shareholders and actually still raise money in a very efficient way because people trust Apple to pay them back.

7:18So Apple has that ability to offer bonds at very low rates in the market and raise money through that, which is cheaper than them offering equity, which is really valuable to shareholders and also Apple. On the flip side, if you're a young company, people don't trust you to pay them back. So you actually can't offer bonds. And if you did, you'd have to pay yields of 40%, 50%, right? And that doesn't make sense to most companies. So younger companies are often forced to issue equity because that's the only route that's available to them. Whereas if you mature, people trust you to pay them back.

7:48So you're able to offer these lower risk investments, still bring on capital so you can fund your business, you can fund your operations, but you don't have to dilute your existing shareholders. And so a lot of people prefer issuing debt because it's cheaper and it doesn't dilute the owners. So you bring up this really important idea of trustworthiness, right? So with governments, the United States is more likely to pay you back. With companies, Apple is more likely to pay you back. with governments, you know, a smaller developing country, not as likely to pay you back if God forbid something happens to that country.

8:20So they have to give you more of a return in order for you to give them your money in the first place. Same thing happens with companies, too. So not every company is Apple. There are smaller companies. There are maybe companies that could face the risk of never paying you back if they go through bankruptcy or something analogous to what a country would go through. So can you explain what the rating system looks like for corporate bonds so you can assess what that trustworthiness is for companies? Sure. And because, right, not everyone's a bond nerd, not everyone's looking through detailed financial statements to try and figure out if this company is paying me back, a lot of people offload that work to credit rating agencies.

8:57Think about your Moody's, your S &P Global. These are companies with thousands of analysts who are really pouring through the details of every bond issuance, going over the company's financial profile. And then they basically give a grade to this debt that says, hey, based on our analysis, we think there's a good chance or a small chance that it will make good on all of their obligations. And the way they do that, folks might have heard of, hey, this is a AAA rated or investment grade, right? These are just different kind of classifications that these credit rating agencies use to divvy up the different bond universe into risky and less risky buckets.

9:30And so for investors, the credit ratings is a really easy way to look at a specific bond and say, hey, this is AAA. I don't have to worry about that one. Someone's done all the work. It's good. It's probably going to pay me back. Oh, this is, you know, a C rating, which is basically a junk bond, right? A high yield bond or what people call junk bonds. They're not that trustworthy. And so because they have a C rating right off the bat, hey, right, red flags, there might be some difficulties with this company going ahead. I should be a little bit more careful. But they go from your triple A, double A is very good.

10:02Single A is good. Triple B, double B, still pretty good. Then you get down into the single B is C's And that's where folks start to have some concerns. And you mentioned high yield or junk bonds. This concept is so funny to me because high yield sounds amazing, right? You're like, I want a high yield, but it's also a junk bond. And then when you hear junk bond, you're like, no, thank you. So can you explain how the yield and the rating work? It's almost like a seesaw, right? Exactly. And just like in the stock market, there's no free lunch. So if you see a high yield on something, if you're looking at something and you're looking at two bonds, one is going to pay you 5 % and one's going to pay you 20%, red flags, red alarms should go off in your head.

10:46That 20 % bond, if they make do, could be a good investment. But the reason that it is so high and so much higher than everything else is because the market has really strong concerns that they may not pay you back. And so in the bond market, if you look at something and it's too good to be true, chances are it may be too good to be true. And you may want to pass on that high yield because in actuality, you may not get that at the end of the day. Apple is not going to give you 20 percent. Exactly. So Apple, unfortunately, barely gives you more money than the U.S. government because some people trust Apple more than the U.S.

11:19government. And so for companies like that, you really are only getting a small amount of extra income. Whereas if you do look into a company who is less mature than Apple, you can pick up greater yields. And there's a big way between Apple and a company that's going to default. As I said, there's 1.5 million bonds. And so there's a huge middle ground for people to look at. And there are still very attractive places where, sure, Apple might give you 4.5 percent, but there might be a pretty attractive company that's going to pay you 6 percent or 7 percent. And that's actually not too bad in this environment.

11:51So you want to just assess the risk and the reward because you're not going to get low risk and high reward. Something's going to have to give. Like you said, you explained it really well. No free lunch here. So anything triple B negative and above is considered investment grade. For our normal credit scores as individual humans, we have a lot of different factors, right? Utilization score, debt repayment history. What goes into the factors for these companies and how they're rated? A lot of it is, a lot of it can be how much money that they're actually making. So what are their profits every year?

12:26Because their profits are what they are able to pay back, right? These bond investors. And if they don't have profits, then they have to figure out some way to how to generate this cash flow to give to their bond investors. Because remember, they guaranteed these bond investors that they're going to pay them every year. And so this company better be sure that it's making profits every year in order to pay them. So a lot of times it's just, is this company profitable and is it continuously profitable over time? Because you don't want five years of no profits because then they're going to have trouble paying these interest payments.

12:56Which brings us to another important part. How much debt do they currently have? the more debt that a company has, the more money they are guaranteed to pay out of their company every year. And so if profits go down, their fixed amount that they have to pay out is still the same. And so if they have more debt, they have more obligations to pay out. And if their business is running into trouble, they're going to have more difficulty paying those interest obligations. So a lot of it is, hey, how is this company doing? Are they generating enough profits in order to pay these bond investors what they obligated to pay them?

13:27And two, how much other debt do they have on their balance sheet because in case something goes wrong, they don't want to get into a situation where they have so much debt, they have so many obligations every year to pay out that it's just not viable from their business standpoint. So I guess for individuals, for companies, a debt to income ratio is important. Exactly. Because if you have too much debt, people get worried that you have too much interest to pay and you may stumble and not be able to pay it. And so that can be a real challenge to folks. And you mentioned investment grade bonds like Apple would be the gold standard, right?

13:59Just paying a little bit more than U.S. Treasuries. What is the average, though, for investment grade bonds? So from Apple to anything triple B. So a lot of times people talk about a spread to Treasury. And what that means is by paying the government, they can raise taxes. They're never not going to pay you back. But there is a risk to a company to not pay you back. And so in order for an investor to purchase a corporate bond over a treasury, they have to be compensated extra because there is a little bit of risk, might not be a lot, but there's some risk above zero that this company could default.

14:33So effectively, every corporate bond is a little bit more than a treasury. So if you think about a AAA rated bond and the treasury is paying 4.5, they may pay 4.5. A AA bond, maybe 4.7. And so as you kind of get lower and lower credit rating, you start to see kind of these averages creep up and up. And so that when you get to call it the high yield bonds, those are paying, call it 8%. And so I think that's generally the way we think about these different levels of risk pay effectively certain amounts above a treasury. And so low risk ones may only pay 1 % above a treasury. High risk ones may pay 5 % above a treasury.

15:12And so as rates, treasury rates go down, these yields will also go down, but the difference between the treasury rate and the corporate bond rate should remain constant. So to actually answer your original question, these bonds are generally paying about 2 % on average more than treasuries. Okay. And so we're ideally staying in the universe of investment grade bonds, not necessarily junk bonds, but just for funsies, what would junk or AKA high yield, AKA non-investment grade bonds be going for? What kind of rates are you seeing there? So the safer ones, because there is a range even within the junk space, the safer junk bonds I would say are earning, call it 7 % to 8%.

15:55And the really risky ones, right, could be anywhere from 20 % to 40%. But those are that high because of other issues that we've talked about. But generally speaking – What's an example of one of those? AMC is a great example. AMC bonds are paying 15 % to 20 % at the moment. And what kind of risk would you expect with a company like AMC? What if you're like, I love movies and it's a meme stock and 20 % sounds amazing. But what realistically is the risk that somebody could expect if they bought a corporate AMC bond? It's a good story. AMC is a very specific company because of its meme status. So on the one hand, the company is not doing that great, right?

16:34Not many people go into the movies. Profits really aren't there. They don't have much growth potential. So that's why the bonds are trading very low because people are like, not a great company. On the other hand, because they're a meme stock, they're able to raise a lot of capital in the equity markets. And this goes back to if they are raising a bunch of money in the equity markets, that adds a buffer between the debt holders and the company. And so it makes their bonds safer. So in AMC, it's actually been like a little bit of an awkward effect that doesn't happen in the market just because their stock is pumped so high that they can raise equity for really, really cheap compared to their debt.

17:09And we delineated between investment grade and non-investment grade. There's also secured bonds and unsecured bonds, right? Can you explain the difference? So secure bonds are generally backed by some asset. So for instance, if you have a mortgage, right, that is a bond that is a secured bond, because if you default, they can claim your house and sell the house. So it is secured by something. Whereas many bonds of corporations, right, when they issue it, it's just backed on, hey, is this company going to do well or not? And so secure bonds can be very good, right, if they're backed by government revenues.

17:46For instance, a lot of municipal bonds, which we haven't talked about much, right, a lot of municipalities issue bonds to fund stadiums or schools or things like that. Those are often secured because there's some tax base that is literally funding, you know, these bonds behind the scenes. And so that's the difference between secured and unsecured. Secured generally has some type of asset that you can claim under a default, whereas unsecured is, hey, this company defaults. You just have to go through the bankruptcy court and see what shakes out at the end. And there's a creditor list if something like that happens.

18:16Is there a way to get your money back? There is a way to get the money back. And that's a very good point, I think, and the major difference between bonds and stocks and why bonds are much less risky than stocks. Because in most bankruptcies, and it's funny, who actually triggers a bankruptcy? the bondholders. So that's, I think that's an interesting part, right? So bondholders, everyone's worried about, Hey, they're going to default, but bondholders, the one that are saying, Hey, I'm looking at this company. I'm getting worried. They're not going to pay me back. I'm going to trigger a default to make sure I get my money back.

18:49But when that happens, all the equity holders, all the stockholders pretty much get wiped out. And so you're left with all these bondholders saying, Hey, we know this company worth something. We know we're owed something. We want to take all of our money back. And so they go through the courts. The company sells off everything they can, right? They're left with a bunch of assets. And then the bondholders say, okay, I have the first claim to those assets in order to get paid back. And generally speaking, even when companies go bankrupt, bondholders get 70, 80, 90 cents on the dollar back because they're the ones first in line saying, hey, you got to default because you got to pay me back right now because I don't trust you to pay me back in a year or two.

19:28And so that's why bondholders actually are relatively low risk because even in the event of a default where stockholders get right, written down to zero, bondholders actually get a fair amount of their money back. And they're always at the top of the stack. Like in any creditor situation, even personal bankruptcy, you'll have people that get paid first if there's any money retrieved. Every bond is ahead of every stockholder. But it doesn't mean that every bond is first in line because they could have multiple debt and you could be somewhere on the line. You just know you're above the equity holder.

19:57But some bonds are first in line. Some are last in line. It's specific to the individual bond. So if I'm thinking about buying a corporate bond, is that something I want to take a look at? Obviously, take a look at the rating. Take a look at whether or not it's secured or unsecured. What else would I want to know? I think the thing that we haven't talked about is your time horizon. So we look about what is the maturity date on this bond? If it's a risky company, but they're going to pay you back in three months. Maybe it's not that risky. If it's a risky company, but they're scheduled to pay you back in 30 years, right?

20:30That's a little bit more of a wager that you might want to make. And so I think one of the big things is what is my time horizon and how much time do I want to give this company to pay me back? Because it can be a risky bond, but if it's only a one-year bond or a two-year bond, the risk is not as great as if it were a longer bond. So one of the ways that investors can reduce their risk and still earn high yields is keeping their maturity short because that just reduces the future time period for that company to run into trouble.

21:03Hold onto your wallets. Money Rehab will be right back. And now for some more Money Rehab.

21:16Some bonds might be callable too, right? Can you explain that? Yeah. So a lot of bonds in the corporate space are callable. And what that means is that it is an option for the issuer to basically say, hey, you know, we knew we originally said this bond was going to mature in five years. After two years, we're allowed to pull all those bonds back for a certain price. And so it is an option that the issuers can place on this bond when they issue it that increases the yield because it's a benefit to the issuer, which is a negative for the bondholder. So bondholders get higher yields for callable bonds.

21:52But there is this risk that they buy a bond and they expect to hold it to maturity. but all of a sudden the company says, Hey, no, I'm going to call that bond back, give you your money back right now, as opposed to the maturity date. And so the risk to investors is, Hey, you think you lock in a guaranteed yield for five years. I locked in right 5 % for the next five years. I'm super happy in two years, right? That company could call it. I get my money back, which is great, but now interest rates are 2%. So I'm like, now I don't have my 5%. Now my best thing is 2%. And so callable bonds can create this, can create a risk where you get called and then your other opportunities are not as good as they were when you originally purchased the bond.