Corporate bonds are debt obligations issued by corporations. Investors buying corporate bonds lend money to a corporation so it can fund capital improvements, debt refinancing, expansions, or other types of projects. In return, the corporation agrees to pay back the investor’s principal plus additional interest. Like most bonds, corporate bonds typically feature fixed time horizons and fixed interest yields.
Many investors opt for these types of bonds because they are a less risky alternative to stocks and can generate sizable returns. Corporate bonds often offer greater opportunities for higher returns than government bonds or treasury bonds. However, the stock market still tends to outperform corporate bonds overall. Corporate bonds are often incorporated to help diversify an investment portfolio, act as a source of passive income, and even provide additional income for retirees.
How Do Corporate Bonds Work?
A corporate bond is essentially a loan to a company for a predetermined time frame. The company promises to make interest payments towards the investor, typically every 6 months, throughout the entire duration of the bond. The payments a company makes to investors are called coupon payments. Once the bond matures, the corporation returns the entire principal back to the investor.
Suppose you invest $1,000 into a corporate bond that pays a fixed-rate, or coupon rate, of 5%. You’ll receive $50 a year in coupon payments until the bond matures, at which point you should receive your entire principal back as well. Corporate bonds have timeframes that can range from 1 year to over 10 years. Bonds with longer time frames tend to be seen as riskier, however investors are typically compensated with higher returns.
The coupon rate on a bond depends on a variety of different factors, including the yield on U.S. treasury bonds, the maturity date, the credit rating of the corporation issuing the bond, the inflation rate, and other macroeconomic factors.
There’s always some degree of risk when it comes to investing, and corporate bonds are no exception. However, corporate bonds are typically safer investments than stocks. This is because companies have a legal obligation to make interest payments and repay investors’ principal. On the other hand, there’s never a legal obligation to pay dividends or reimburse shareholders.
The biggest risk associated with bonds is that a company will default and be unable to make interest payments or repay the principal of a bond. You can measure the riskiness of a bond by looking at it’s default risk. Bonds receive credit ratings from credit agencies which investors can review.
How To Invest In Corporate Bonds
You can invest in corporate bonds the same you invest in stocks, ETFs, mutual funds, etc. — namely through your broker or brokerage firm. It’s important to note that there are two markets when it comes to buying bonds — the primary market and the secondary market.
The primary market sells new bond issues at a pre-determined price that’s been negotiated by the corporation and institutional investors. The primary bond market is equivalent to an initial public offering (IPO) and therefore only institutional investors are able to buy bonds in the primary market.
Most investors will buy and sell already-issued corporate bonds from other investors through their broker in what’s known as the secondary market, or over the counter (OTC) market. Investors can also access bonds through index funds or mutual funds.
The price of the bond can fluctuate in the second market depending on demand and interest rates. It’s generally recommended investors work with a broker or financial advisor to identify corporate bonds that would be a worthwhile investment.
Corporate Bond Ratings
Corporations that issue bonds are given a corporate credit rating, otherwise known as bond ratings. Bond ratings are one of the most important pieces of information investors will want to consider before buying bonds. Credit ratings show the likelihood a company will default on its debt obligations and be unable to make coupon payments or pay back principal. There are three main credit agencies that monitor and assign bond credit ratings, Moody’s, Standard & Poor’s, and Fitch.
Bond credit agencies will look at a corporation’s balance sheet, profit margins, earnings growth, tax burden, industry outlook, and other macroeconomic factors in order to assign a credit rating. The highest credit rating a bond can be assigned is AAA or Aaa. The lowest rating rating is either a C (on Moody’s scale) or D (on the Standard & Poor’s and Fitch scale),
Bonds with a rating of BBB (on the Standard & Poor’s and Fitch scale) or Baa (on Moody’s) or higher are considered to be investment-grade bonds. Investment grade bonds are generally less likely to default.
The credit rating a bond receives has implications for both its price and coupon rate. Higher rated bonds, like investment-grade bonds, will feature lower coupon rates because they are less risky. Non-investment grade bonds, also called high-yield or speculative bonds, typically feature higher coupon rates in order to compensate inventors for additional risk.
Other Types Of Bonds
Corporate bonds aren’t the only types of bonds available to investors. There’s also government bonds and municipal bonds. Both work in a similar fashion as corporate bonds, with the biggest difference being who’s issuing the bonds.
Government bonds are issued by national governments to raise money for public spending. Depending on the government issuing the bond, risk-levels can vary. U.S. government bonds are typically considered to be risk-free in terms of default. While bonds from certain foreign governments or failed states have been known to default.
U.S. bonds typically pay investors a low coupon rate and are exempt from local and state taxes. The primary risk investors face when purchasing U.S. government bonds come from inflation. If the inflation rate rises faster than the coupon rate, investors will see lower returns in real terms.
Municipal bonds are issued by local governments, such as states, counties, and towns. Like government bonds, municipal bonds are issued to raise money for public spending projects such as infrastructure or schools. Also like government bonds, municipal bonds are generally seen to have low default risk.
Municipal bonds are also usually exempt from federal, state, and local taxes — making them essentially tax-free. For this reason, municipal bonds are a popular investment among people in high income tax brackets.
Who Should Invest In Corporate Bonds?
Corporate bonds can be a sound investment for investors looking for higher returns in comparison to government or municipal bonds. Corporate bonds are generally thought of as less risky than stocks and offer a relatively stable source of passive income. Like all bonds, corporate bonds pay investors income in the form of coupon payments.
Corporate bonds are also considered liquid investments, meaning investors can easily buy and sell bonds. It’s common for investors to sell bonds before their maturity on the secondary market.
However, corporate bonds do come with their fair share of risks. Investors are typically exposed to default risk and inflation risk when holding corporate bonds. While default risk can be mitigated by investing exclusively in investment grade corporate bonds, inflation risk is more difficult to avoid. If inflation grows rapidly, investors will reap lower returns or even negative returns altogether.
It’s best to consult with a financial professional, like a broker or financial advisor, before deciding whether corporate bonds would be a wise choice for your investment portfolio. A financial advisor for instance, can provide guidance on which corporate bonds to invest and help you develop a personalized strategy. Don’t know where to start? Read up on how to find and choose a financial advisor here.