Corporate bonds can offer a higher yield for your investment, but the higher yield also means higher risk. Most corporate bonds are debentures, meaning they are not secured by collateral. Therefore, it is important that investors of corporate bonds know how to assess the credit risk and its potential payoff. The investor can check with Moody's, Standard & Poor's, and Fitch Ratings to find out about the credit ratings of companies. The only problem with these publications is that the institutional investors in corporate bonds supplement the ratings with their own credit analysis. There are two main tools to use in order to assess credit risk: interest-coverage ratios and capitalization ratios.

How much money does the company generate each year in order to pay the annual interest on its debt?  This is shown by the company’s EBIT (earnings before interest and taxes) divided by annual interest expense. A good rule of thumb is that, for a company to generate enough earnings to service its annual debt, this ratio should well exceed 1.0. The higher the ratio, the better.

How much interest-bearing debt does the company carry in relation to the value of its assets? Calculate this ratio as long-term debt divided by total assets. This shows the company’s degree of financial leverage. Junk bonds are examples of very high-risk factors. In general the greater the risk factor, the less you should buy directly into a single corporate bond issue.

Investors should also be aware of two more risks: call risk and event risk. An event risk is the possibility that a corporate transaction, natural disaster, or some sort of change will cause a quick downgrade to the corporate bond. You might find an event risk if the telecommunications industry is consolidating: a telecom company might buy another company, possibly increasing its debt burden. 

A call risk deals with whether the bond is “callable,” meaning the issuing company has the right to purchase the bond after a specified time. For example if you hold a high-yield bond and the interest rates drop, the company has the right to call in the bond and reissue it at a lower interest rate. Always make sure that you are compensated for the call provision by getting a higher yield rate.

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