Corporate bonds are debt securities issued by corporations and sold to investors. Corporations use corporate bonds to raise capital, and investors earn interest on the bonds.
When you purchase a corporate bond, you’re essentially loaning money to the company. It’s not like buying stock in the company, in which you own part of the company. With a bond, you’re a lienholder, not an owner. In most cases, the company agrees to pay back the principal as well as interest.
Usually, the interest on corporate bonds is higher than on government bonds. That’s because government bonds such as U.S. Treasury bonds have the backing of the government, but corporate bonds are backed only by the company’s ability to pay through future operations or physical collateral. That involves more risk so it warrants higher interest rates.
How are corporate bonds rated?
Every bond has a rating, or a grade that indicates its quality, to help investors determine whether the bond is a wise investment. Various rating agencies such as Moody’s, Standard and Poor’s, Fitch Ratings and DBRS assign ratings to a firm’s bonds.
Agencies base their ratings on the bond issuer’s financial strength, growth potential and ability to repay its obligations. That ability doesn’t just depend on the company’s balance sheet. Rating agencies also consider local government agencies, partnerships or parent companies and other measures depending on the company’s industry.
Bonds are assigned ratings between AAA and D, with AAA ratings representing the most financially secure companies. While a higher rating means more security for investors, more risk often results in a higher yield. So purchasing a AAA-rated bond is safer, but purchasing a B-rated bond may result in higher earnings.
Bonds can be either investment grade or non-investment grade, based on their credit ratings. Investment grade bonds are considered more likely to be paid on time. Non-investment grade, also called high-yield or speculative bonds, usually offer higher interest rates to compensate investors for taking on greater risk.
How do you purchase corporate bonds?
You can purchase corporate bonds through brokerage firms, banks, bond traders or brokers, or you can purchase them on the over-the-counter market.
Corporate bonds are issued in blocks of $1,000 in value, and some are sold only in blocks of $5,000 or $10,000. Prices for bonds are quoted as a percentage of face value. For instance, if a bond is selling at 90, that means it can be purchased for 90 percent of its face value. In that case, a $1,000 bond would cost the investor $900.
How do you earn bond income?
Owners of corporate bonds usually earn interest from the company until the bond matures. Interest payments on bonds are called coupon payments, and the interest rate is called the coupon rate.
Some bonds have fixed interest rates that remain the same throughout the life of the bond, while others have floating interest rates that are reset periodically, such as twice yearly, based on market factors.
However, zero-coupon bonds make no interest payments until the bond matures. Instead, when the bond matures, the owner is paid principal plus interest in a single payment. For instance, say you pay $700 to purchase a five-year, zero-coupon bond with a face value of $1,000. After five years, the bond will mature and the issuer will pay you $1,000, which is equal to the purchase price plus interest, or original issue discount, of $300.
Whether you earn interest or not throughout the life of the bond, when the bond matures you can reclaim its face value. So if you purchased a five-year, $10,000 corporate bond, the company must pay you $10,000 after the five years are up. If you decide not to wait that long, you can usually sell the bond before it matures.
What happens if the company can’t repay its bond debts?
Like all investments, corporate bonds do carry some risk. One key risk to a bondholder is that the company may fail to make agreed upon payments of principal and interest.
However, if a company gets into financial trouble, it is still legally required to make timely payments of interest and principal to bondholders. In a bankruptcy, bond investors are prioritized over shareholders in claims on the company’s assets.
Before purchasing corporate bonds, it’s important to pay attention to the company’s creditworthiness and default risk to ensure that it will have the ability to pay its debt obligations on time.
Investing in corporate bonds can be a good strategy for adding some diversity into a portfolio that’s heavy on stocks. But before sinking your money into corporate bonds, take time to determine whether the company is a worthy debtor. Remember, you’re essentially loaning the company money, and nobody wants to lend money to those that are unlikely to repay, and unlikely to repay on time.
Investing involves risk including loss of principal. This article contains the current opinions of the author, but not necessarily those of Acorns. Such opinions are subject to change without notice. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.