Corporate bonds are a way to invest in a company, allowing you to bet on its continuing success in a way that has lower risk and lower returns than stocks. Bonds provide regular cash payments, and their prices tend to be less volatile than company stocks. For investors who are willing to take on a little more risk but are looking for higher returns than CDs can offer, bonds can be an attractive option.
Learn what corporate bonds are and the risks and benefits for investors of investing in corporate bonds.
What are corporate bonds?
A bond is a way of providing financing to an organization and is a contract in which the borrower (the bond issuer) agrees to lend a certain amount of money (principal) in exchange for paying a certain amount of interest to the lender over a certain period of time. When the bond matures at the end of the period, the borrower repays the bond's principal and the contract is closed.
Corporate bonds are debt securities issued by corporations, often publicly traded companies. They are distinct from debt securities issued by other organizations, such as Treasury bonds issued by the U.S. federal government and municipal bonds issued by state and local governments.
How interest is paid on corporate bonds
There are two main types of bond interest payments: fixed and floating. With a fixed-rate bond, interest payments are made according to an exact agreed-upon rate, and that's all the investor receives. With a floating-rate bond, interest payments can go up or down, often depending on the current interest rate environment.
Bonds make periodic interest payments, usually semi-annually, but sometimes quarterly or even annually. The payments on a bond are called coupons, and coupons don't change unless initially detailed in the bond's terms. For example, a fixed-rate bond might offer a 4 percent coupon, which means it pays $40 per year for every $1,000 of face value.
Corporate bonds typically have a face value of $1,000, which is usually the minimum amount to buy a bond, but bond ETFs allow you to buy a diversified portfolio of bonds for a much smaller amount.
If a company cannot pay the interest on its bonds, it goes into default. Defaulting on a bond can ultimately lead to the company declaring bankruptcy, and depending on the company's debt situation, investors may get nothing out of their bond investment. However, in the event of bankruptcy, bond investors will get paid before shareholders.
What are the risks and benefits of corporate bonds?
Corporate bonds have many risks and benefits, and investors looking to buy individual bonds need to understand the pros and cons of bonds compared to other options.
Benefits of Corporate Bonds
- Regular cash payments. Bonds provide regular cash payments, an advantage that stocks don't always offer, and they offer a high degree of income certainty.
- There is little price fluctuation. Bonds tend to be much less volatile than stocks and fluctuate in response to a variety of factors, including interest rates (more on this later).
- Less risky than stocks. Bonds are less risky than stocks and are one of the best low-risk investments. For a bond investment to be successful, a company essentially just needs to survive and pay off its debts, whereas for an equity investment to be successful, a company not only needs to survive but also thrive.
- They can potentially offer higher yields than government bonds. Corporate bonds tend to have higher yields than comparably rated government bonds. For example, interest rates on corporate bonds are generally higher than the interest rates on the safest U.S. government bonds, but not all corporate bond rates are higher than the interest rates on all government bonds.
- Access to secondary markets. Investors can sell their bonds in the bond market, providing a liquidity outlet for their bond holdings, an advantage not available with bank CDs.
Disadvantages of corporate bonds
- Fixed payment. The interest rate on a bond is set when the bond is issued, and that's all you get. With a fixed-rate bond, you know all of your future payments. With a floating-rate bond, your payments may fluctuate, but you know the terms. This is in contrast to dividend stocks, which can grow their dividends for decades.
- They can be riskier than government debt. One reason corporate bonds offer higher yields than safe government bonds is because they are riskier. In contrast, governments can raise taxes or print their own currency to pay off their debts if they need to.
- The likelihood of capital appreciation is low. Bonds are unlikely to appreciate in value. All you can expect from a bond is a yield to maturity. In contrast, stocks can continue to rise for decades and make a lot more money than bonds.
- Price fluctuations (unlike CDs). Bond prices generally don't fluctuate as much as stocks, but unlike CDs, they do fluctuate, so if you need to sell your bond at any time for any reason, there's no guarantee you'll get your full amount back.
- There is no insurance coverage (unlike CDs). The bonds are not guaranteed, unlike CDs, which are FDIC insured, so it is possible you could lose the principal amount of the bond, or the company could default on the entire bond, leaving you with nothing.
- Bonds require analysis. Investors buying individual bonds need to analyze the company's ability to repay the bond, so investing here requires effort.
- It is affected by rising interest rates. When interest rates rise, bond prices fall, and investors often don't get the benefit of rising dividends to compensate.
While the risks may seem substantial, the U.S. bond market remains a popular destination for large asset managers to park their capital and earn returns, but you should be aware of the risks, as bonds typically offer limited upside risk at the expense of significant downside risk.
How to buy bonds
When a company first issues a bond, it is usually purchased by institutional investors or other investors with large amounts of money. These large investors can then sell the bond at any time in the public bond market, where individual and other investors can purchase the bond.
Buying bonds is easy, and major brokers like Interactive Brokers, Fidelity Investments, and Charles Schwab make it easy to buy individual corporate bonds. Many companies offer multiple series of bonds, so all you need to do is enter the issuer and choose the maturity of the bond you want.
In the market, bond prices fluctuate. Bonds that are priced above their issue price are called premium bonds, while bonds that are priced below their issue price are called discount bonds. Bond prices fluctuate for a variety of reasons, including:
- Issuer rating downgrade: If a rating agency downgrades a company's rating, the value of that company's bonds may fall.
- The company's business declines: Investors may lower the price of a company's bonds if they believe a declining business could mean the company will have trouble paying back its debt.
- Interest rate trends: The price of an existing bond will rise or fall in the opposite direction to interest rates: when interest rates rise, the price of the bond will fall, and when interest rates fall, the price of the bond will rise, as you can see from the chart.
Because bond prices fluctuate and yields change, you should look at a bond's yield to maturity to see what kind of return the bond will give you. Premium bonds offer a yield to maturity that is lower than the stated coupon, while discount bonds offer a yield that is higher than the coupon.
How bonds are rated
Bonds are rated based on the quality of the issuer. The higher the quality of the issuer, the lower the interest rate the issuer will pay, all else being equal. This means that investors will demand higher returns from companies or governments that they perceive as riskier.
Bonds are broadly divided into two categories based on their ratings.
- Investment Grade Bonds: Investment grade bonds have a low risk of default and are considered to have good to good credit risk. Top-tier companies benefit from investment grade ratings and can therefore pay lower interest rates.
- High Yield Bonds: High yield bonds, also known as “junk bonds,” are considered to be riskier, though not necessarily very high, depending on their ratings and financial standing. Many well-known companies are classified as high yielding while still making steady interest payments.
In the United States, bonds are rated by three major rating agencies: Standard & Poor's, Moody's, and Fitch. The highest quality bonds are rated Aaa by Moody's and AAA by S&P and Fitch, and go down from there. A Baa3 rating by Moody's and BBB by S&P and Fitch are considered the lowest investment grade ratings. Anything lower than this is considered high yield or junk.
Why we prefer bond ETFs over bonds
Bond ETFs are a great way to buy corporate bonds instead of picking individual stocks. Bond ETFs allow you to buy a wide variety of bonds and tailor your purchases to the types of bonds you want, all with one fund.
The advantages of bond ETFs are:
- Diversification: Corporate bonds come in many different types depending on their maturity (short-term, medium-term, long-term) and rating quality (investment grade or high yield). Bond ETFs allow you to buy bonds from many companies with one fund, reducing risk.
- Reduced analysis effort: When you buy a bond ETF, you don't have to analyze companies like you would if you were buying individual corporate bonds. You can buy the types of bonds you want, and the diversification of the fund reduces risk.
- Low minimum investment: A typical bond has a face value of $1,000, but a bond ETF lets you buy a collection of bonds for the price of a single share (as little as $10) — or even cheaper if you use a broker that allows you to buy fractional shares.
- Less expensive than buying individual bonds: Bond markets are typically less liquid than stock markets and have wider bid-ask spreads, resulting in higher costs for investors. With bond ETFs, you can use fund companies to get better pricing and reduce your own expenses.
- Liquidity: Bond ETFs are typically more liquid than individual bond issues.
These are some of the reasons why investing in bond ETFs is an attractive option for investors, even advanced investors, whether you're looking for corporate bonds or other fixed income.
Conclusion
If you have an equity-heavy portfolio, especially one that's prone to volatility, corporate bonds are a good way to diversify, but rather than buying individual bonds, it might make more sense to buy a bond ETF and enjoy the increased safety of a diversified fund.
Editorial Disclaimer: All investors are advised to conduct their own independent research into any investment strategy before making any investment decision, and please note that past performance of any investment product is no guarantee of future price appreciation.