Corporate Bonds Funds

Corporate bond funds are mutual funds that invest in domestic corporations by purchasing bonds from them. Corporate bond funds invest in short-term, intermediate (or medium) and long-term bonds that have maturity dates ranging anywhere from three to thirty years. During their holding period, the bonds earn interest income on a monthly basis.

Planning Note The interest income earned from corporate bond funds is subject to income tax. If you're paying tax on your investment, this obviously reduces the return on your investment. Therefore, if you're not at an age or stage in your life when you need an income stream from the bond fund, or if you're investing for a specific purpose, such as college or retirement, investing in corporate bond funds through tax-deferred vehicles (such as Section 529 plans) makes wise financial sense.

Determining the interest rate. The interest rate you receive on corporate bonds depends on several factors, including general economic factors such as inflation, interest rates and the length of the bond's maturity. Generally, longer-term bonds and, to some extent, intermediate term bonds pay higher interest rates as an incentive for investors to lock in their funds for such a long period of time.

The interest rate you receive on corporate bonds depends even more so on the strength of a corporation's finances. The stronger that a corporation's credit record is, the less interest you'll receive on bonds it issues. Why? It's the risk vs. safety feature. The safest bonds, those issued by financially strong corporations, will attract investors for the safety of their investment. Corporations with lower credit ratings must pay higher interest rates for their bonds in order to encourage investors to take more of a risk.

Sometimes the interest rate paid for corporate bonds is also affected by whether the bond is backed by specific assets of the corporation rather than the corporation in general. Bonds backed by specific assets are generally safer because you can file a specific claim if there's a payment problem. As a result, the interest paid on corporate bonds backed by specific assets is usually lower than the interest paid on a company's general bonds.

Warning Many corporate bonds can be redeemed (it is known as a callable bond in the financial industry) before their maturity date. Corporations want this feature for their bonds because, if an investor locks in a high interest rate for a 20-year term, the corporation will want to get out of this deal if the interest rates drop. Can a corporation do this? They can if this is one of the features of the bond. If a corporation exercises this feature, a 20-year bond could be called and redeemed for face value years before the 20-year period is over. The fund then has the option of buying the corporation's bond again, but at a lower interest rate. Obviously, this feature has an effect on your investment return.

Index funds. Of the various investment vehicles available, a popular method of investing for many corporate bond funds is through a bond index fund. Index funds are funds that invest in all the bonds in a particular bond index. For example, a mutual fund might use a short-term, medium-term and long-term bond index to diversify and protect itself against fluctuations in the market. If you invest in an index fund, your returns would match the returns of the index it's based on.