Corporate bonds are debt securities issued by companies to raise capital for business operations, expansions, and other investments. In exchange, companies promise to make regular interest payments to bondholders and repay the principal when the bond reaches maturity.
For income investors, corporate bonds can provide higher yields than ultra-safe government debt while taking on manageable risks. They occupy an interesting middle ground between low-interest savings vehicles like CDs and inherently volatile stocks. This comprehensive guide will explain everything you need to know about corporate bonds, including pros, and cons, different types, credit ratings, yields, risks, and more.
Demystifying Corporate Bonds
A corporate bond represents a loan made by an investor to a company. The company issues bonds when it needs to raise capital, whether for funding daily operations, new equipment purchases, facility expansions, or other business needs. Each bond has a face value, also called par value, which is usually $1,000 per bond. The company promises to repay the face value when the bond reaches maturity, which can range from 1 year up to 30 years for most corporate bonds.
In exchange for the loan, the company also promises to make regular interest payments to bondholders. These payments usually occur semiannually at a stated interest rate based on the bond’s credit rating and market conditions at issuance. So investors earn interest income by holding the bond over its lifetime, then get their principal back at maturity.
Bond investors don’t gain any ownership stake in the issuing company. That key difference separates corporate bonds from equities like preferred and common stock. As creditors, bondholders have a senior claim on company assets and earnings relative to shareholders if the company declares bankruptcy. However, stockholders have a potential upside if the company performs well, while bondholders earn fixed interest and principal payments.
Corporate bonds are issued with maturity terms ranging from 1-30 years. Short-term bonds under 12 months are considered commercial paper. Bonds with 30-year maturities are less common than intermediate terms of 1-10 years. The prospectus gives the bond’s final maturity date when the company will repay the principal.
Some bonds have call provisions allowing the company to redeem them early under certain circumstances. For example, if interest rates fall substantially after issuance, the company may refund old bonds by calling them in and issuing new ones at lower rates. This benefits the issuer but can reduce profits for investors.
Key Reasons Companies Issue Bonds
Companies sell bonds to institutional investors and the general public through a process called a new issue. The capital raised can be used to fund:
- Capital expenditures like new equipment, land, facilities, etc.
- General operating expenses and working capital
- Refinancing existing debt at lower interest rates
- Mergers and acquisitions
- Expansion into new markets or geographies
- New product development and marketing
- Other business needs
Bonds allow companies to borrow at lower costs than bank loans or lines of credit, especially for highly rated investment-grade firms. They offer fixed interest rates over long terms, reducing uncertainty in budgeting debt service expenses. Companies can also deduct interest expenses on corporate debt for tax purposes.
The borrower’s perspective contrasts with the investor’s perspective. Investors buy corporate bonds to earn interest income at predictable fixed or floating rates. They also hope to get repaid at maturity. Companies benefit from low-cost financing while investors receive reasonable returns for assuming credit risk.
How Companies Issue Bonds to Investors?
Before bringing new bonds to market, the issuing company must publish a prospectus registered with the SEC. This document describes all of the bond’s key terms and disclosures important for investors to know. Items covered include:
- Use of proceeds from the bond sale
- Interest payment amounts and schedules
- Maturity term and early call provisions if applicable
- Bond credit ratings from major agencies like S&P
- Ranking compared to other company debt obligations
- Financial information on company performance and risks
- Management biographies and compensation
- Legal and tax considerations
The prospectus allows potential investors to evaluate the risks and potential rewards of buying the bond. After its publication, the issuer sells the new bonds during the primary market offering. Most individual investors don’t participate in new issues since underwriters sell blocks of bonds to large institutional buyers. Individuals must wait to buy bonds in the secondary market.
Once issued, bonds trade over the counter on the secondary market between investors. The market price fluctuates above or below face value depending on the issuer’s creditworthiness and prevailing interest rates. Lower rates raise prices and vice versa. Investors hope to sell at a premium before maturity.
How Interest Rates Work on Corporate Bonds
Interest rates compensate investors for loaning money and taking credit risk. Each bond has a stated rate determining how much interest the company must pay annually as a percentage of the principal. Most corporate bonds make semiannual interest payments. Zero-coupon bonds don’t pay periodic interest but accrue it over the bond’s life.
Interest rates correlate strongly with the bond issuer’s credit rating when first issued. Companies with higher creditworthiness and lower risk of default pay investors lower rates. Speculative-grade companies with higher default risk must pay higher rates to attract buyers. For a given issuer, rates also depend on maturity terms. Longer terms mean more interest rate and inflation risk over time, so issuers pay higher rates on 30-year bonds versus 5-year bonds.
Other key rate factors include prevailing benchmark Treasury yields and economic growth expectations. As Treasury rates rise, corporate bonds must offer higher rates to remain attractive. Stronger economic growth allows companies to pay lower rates to borrow. Weaker growth compels companies to pay higher rates to offset risks.
Corporate bonds can offer fixed, floating, or variable interest rates:
- Fixed-rate bonds maintain the same rate over their lifetime.
- Floating rate bonds adjust periodically based on benchmarks like Libor or Fed funds rates.
- Variable rate bonds adjust annually based on company performance and credit ratings.
Bondholders earn the highest current income from bonds issued when market benchmark rates are high. However, high rates reflect expectations for slowing growth, higher inflation, and tighter credit. These conditions raise risks for bond issuers, pressuring their credit ratings and stock prices. This dynamic illustrates the inverse relationship between interest rates and bond prices.
How Credit Ratings Affect Corporate Bonds
Independent credit rating agencies like Standard & Poor’s, Moody’s, and Fitch analyze and grade each issuer and bond issue using their own letter-based rating scales. Ratings range from AAA/Aaa for the most creditworthy institutions down to D for companies in default. Bonds with ratings below BBB-/Baa3 are considered non-investment grade, or “high yield” speculative bonds.
Credit ratings determine interest rates because they reflect each issuer’s likelihood of defaulting on its obligations. Other key factors assessed include management quality, profitability, cash flow, leverage, industry dynamics, and the issuer’s competitive position. Changes in performance and creditworthiness cause agencies to upgrade or downgrade specific issuers and bond issues over time.
Investment grade bonds rated BBB-/Baa3 or higher have lower default risk, so issuers pay lower interest rates, typically 3-5% currently. High-yield bonds rated BB+/Ba1 or below have higher default risk, so issuers must pay higher rates, typically 5-10% currently on average. Unrated bonds also pay higher rates since credit risk is unknown. While junk bonds offer higher income, investors accept a greater risk of principal losses and late interest payments.
Credit ratings directly impact bond values in secondary trading. A rating downgrade increases perceived default risk, so bond prices fall to compensate investors with higher prospective yields. Conversely, an upgrade lowers yields as default risk declines. Ratings changes also affect issuers’ borrowing costs when selling future bonds. Higher ratings allow companies to borrow cheaply while lower ratings compel them to pay higher rates.
Analyzing Key Differences Between Corporate Bonds and Preferred Stocks
Corporate bonds share similarities with preferred stocks, which can cause confusion for income investors new to fixed-income markets. However, important differences exist between the two types of securities:
- Bonds are debt obligations while preferred stocks represent equity ownership.
- Bondholders have senior priority over preferred and common stockholders for assets in bankruptcy.
- Preferred stocks often trade on major stock exchanges, offering greater liquidity to buy and sell than most corporate bonds.
- Companies can suspend preferred dividend payments at any time for financial reasons. However, they must pay bond interest under the terms of the indenture agreements unless they default.
- Preferred stockholders may gain upside if the issuer repurchases shares above the purchase price. Bondholders cannot participate in upside beyond receiving principal and interest.
- Bonds have fixed maturities when the principal is returned. Preferred stocks are perpetual capital without a maturity date.
- Some convertible bonds can be exchanged for equity shares under certain conditions. Other bonds don’t offer equity conversion features.
In summary, corporate bonds offer seniority and fixed payments but lack upside potential. Preferreds offer equity exposure and lack fixed maturity dates but have a greater risk of suspended dividends. These differences help explain the narrower trading ranges of corporate bonds relative to potentially more volatile preferred stocks.
Examining the Various Types of Corporate Bonds
Many types of corporate bonds exist, each with distinct features and risks. Some of the major bond categories include:
- Secured Bonds – Backed by collateral like real estate or equipment to help ensure repayment to bondholders if the issuer defaults.
- Unsecured Bonds – Not backed by any specific collateral assets. Increased default risk is compensated by paying higher interest rates.
- Senior Bonds – Have first priority repayment in bankruptcy before other unsecured corporate debt. Very low default risk.
- Subordinated Bonds – Have lower priority for repayment behind senior bonds and other obligations. Higher default risk means higher yields.
- Investment Grade Bonds – Rated BBB-/Baa3 or higher by rating agencies with lower default risk and lower interest rates.
- High Yield Bonds – Rated BB+/Ba1 or below with higher default risk commanding higher interest rates for investors. Also called junk bonds.
- Floating Rate Bonds – Interest rate adjusts periodically based on benchmark rates like LIBOR or Fed Funds rates. Lowers inflation and rate hike risk for investors.
- Callable Bonds – Issuers can redeem bonds before maturity, exposing investors to reinvestment risk at lower rates. Compensated with higher yields.
- Puttable Bonds – Allow investors to request early redemption before maturity. Considered more investor-friendly than callable bonds.
- Convertible Bonds – Can be converted into equity shares of the issuer under specified conditions. Offer fixed income or potential stock gains.
- Zero Coupon Bonds – Don’t pay periodic interest but accrue value to face value at maturity. Deeply discounted purchase prices compensate for the lack of income.
Secured bonds merit special consideration as arguably the lowest-risk option. Their collateral assets help ensure investor repayment in the event of default. However, they also pay the lowest interest rates. Unsecured bonds lack this protection but pay higher yields to compensate.
The Importance of Liquidity When Investing in Corporate Bonds
Liquidity refers to the ability to buy and sell securities easily in the market. Corporate bonds trade over the counter rather than on formal exchanges, which reduces their liquidity versus common stocks. Large broker-dealers known as market makers facilitate trading between investors in thousands of corporate bonds.
However, certain smaller issues don’t actively trade each day. This illiquidity means buyers must pay higher prices and sellers lower prices when transactions do occur. Bond funds provide greater liquidity by owning baskets of bonds and allowing daily redemptions for cash. Individual bonds also gain liquidity as they near maturity within 5 years or less.
Investors demand greater liquidity compensation for holding illiquid longer-maturity bonds. These bonds pay higher yields relative to otherwise comparable liquid bonds. Rating downgrades also hamper liquidity as more investors aim to sell volatile or distressed bonds. However, buying illiquid high-yield bonds allows investors to earn higher returns for tolerating their greater risks.
How Individual Investors Can Buy Corporate Bonds
Individuals have two main options for investing in corporate bonds:
- Purchase individual bonds through a brokerage account
- Buy shares of bond mutual funds or ETFs
Buying individual bonds offers more control over exposures but requires large investments. Bond funds provide diversification across many issues for smaller investment amounts.
New bond issues are hard for individuals to access since underwriters sell them in large blocks to institutions. However, you can use brokerage accounts to buy previously issued bonds trading on the secondary market. Search for bonds matching your needs for yield, credit rating, maturity, and other preferences.
Purchasing minimums for individual bonds are generally $5,000 or higher. Execution costs include bid-ask spreads compensating market-making broker-dealers. It helps to use limit orders when buying to control your purchase price versus market prices. You can also buy newly issued municipal and US Treasury bonds directly from the issuers without a markup.
Alternatively, bond mutual funds and exchange-traded funds provide instant diversification. You can invest in these bond funds starting from just $1,000 or less and add smaller dollar amounts anytime. Low minimums and liquidity make them accessible to most investors. The major drawback is a lack of control over exposures other than general risk categories like investment grade short-term, high yield, etc.
Bond funds do charge management fees and trading costs that detract from returns. Index funds tracking benchmark bond indexes offer lower fees. Actively managed funds aim to outperform the market minus fees. Investors should compare returns net of all fees when selecting bond funds.
Merits and Demerits of Investing in Corporate Bonds
Compared to other investments like stocks and ETFs, corporate bonds offer unique advantages and disadvantages for investors to weigh:
Potential Advantages
- Higher yields than US Treasury and municipal bonds with only moderately higher default risk depending on credit rating
- Less volatile principal value than stocks with senior priority over dividends for asset claims
- Fixed periodic interest payments over the bond’s term, avoiding the uncertainty of stock dividends
- Greater potential upside than CDs, savings accounts, and money market funds
- Rising interest rates boost existing bond yields for investors needing current income
- Diversification benefits for balancing stock-heavy portfolios due to low correlation of returns
Potential Disadvantages
- Credit risk of delayed payments or default if the issuer experiences financial distress
- Interest rate risk of seeing bond resale values decline if market rates move higher
- Lack of participation in stock price appreciation enjoyed by stock and convertible bond investors
- Lack of liquidity magnifies trading costs for certain issues lacking active secondary market trading
- The opportunity cost of earning lower average long-term returns than equities
- Inflation risk that rising consumer prices erode the real value of fixed interest payments over time
On the whole, corporate bonds deserve consideration for medium-term investors needing more income than safe government debt provides. The ability to hold both bonds and stocks allows the creation of portfolios tailored to your individual risk preferences. Their relatively low volatility also makes corporate bonds appropriate for shorter-term savings goals under 5 years, where principal preservation matters most. Weigh the pros and cons based on your investment objectives.
Frequently Asked Questions About Corporate Bonds
What happens when a company defaults on its bonds?
Default begins by failing to make an interest payment on schedule. After 30 days past due, the bond is considered in default. At this point, the bondholder can demand immediate repayment of the principal under default provisions of the bond indenture. However, companies often negotiate with creditors to restructure debt rather than declare outright default. Bondholders may agree to delayed or reduced interest payments, extended maturity, or exchanging debt for equity. Restructuring avoids default but still inflicts losses on bondholders.
If voluntary agreements can’t be reached, bondholders can sue to seize company assets or force bankruptcy. In bankruptcy, secured bondholders get the first claim on collateral assets. Unsecured holders have priority over equities but often recover only a portion of the principal. Recovery rates depend on assets available and negotiating leverage.
How do bond prices move when interest rates change?
Bond prices are inversely proportional to the interest rates. When market interest rates rise, existing bond prices fall to offer higher yields to buyers. Falling interest rates boost existing bond prices and reduce their yields. Longer-maturity bonds see larger price swings from rate changes than short-term bonds.
For example, a 30-year bond paying a 4% coupon would see its market price fall below face value if new bonds demanded 5% yields from issuers. The now "discounted" bond would have to trade at a lower dollar price to match the 5% return available on newer bonds. The opposite happens when rates fall.
Are bonds a good investment when inflation is expected to rise?
Bonds have historically delivered lower returns than stocks during inflationary periods. Rising consumer prices erode the purchasing power and real returns of fixed bond interest payments. However, Treasury Inflation-Protected Securities (TIPS) offer an alternative compensating investors for inflation. TIPS adjusts its principal value semiannually based on the Consumer Price Index while paying a fixed interest rate on the inflation-adjusted balance.
Also, favor shorter-term bonds maturing in 1-5 years over long-term bonds for inflationary periods. You can reinvest proceeds in new issues paying higher rates as inflation drives up yields. Floating rate bonds paying adjustable coupons indexed to inflation or interest rates also merit consideration when inflation is rising.
How risky are junk bonds compared to stocks?
Junk bonds are called “high yield” bonds because their elevated default risk must be compensated with higher interest rates for investors. Historically, junk bonds default on interest or principal at annual rates between 2-4% per year. That compares to about 1% default rates for investment-grade corporate bonds.
However, junk bonds still deliver higher returns for investors due to their high coupon rates even factoring in defaults. According to Fitch, the 10-year annualized default-adjusted return for junk bonds was 6.8% since 1999 compared to 6.6% for the S&P 500. But on a volatility-adjusted basis, junk bonds scored in the 98th percentile versus stocks in the 44th percentile.
How can individuals buy new bonds at issuance?
New bonds are not sold directly to individuals like Treasury bonds. Large investment banks purchase almost the entire issuance to resell to institutional investors like pension funds, insurers, hedge funds, and mutual funds. Individual investors must wait to buy most new corporate and municipal bonds in the secondary market through brokers.
Treasuries are the main exception. You can buy newly issued Treasury bonds, bills, and notes directly from the TreasuryDirect website without a broker. Minimum purchases start as low as $100 and you can reinvest interest payments and maturing securities. Purchasing at issuance lets you maximize total return by eliminating markups imposed in the secondary market.
Some new municipal bonds are also sold directly to individuals. Known as municipal retail order periods, they let you buy blocks of bonds before institutional sales. Check EMMA or InvestingInBonds to search for municipal retail order periods by state. Corporate bonds don’t offer direct purchase options for non-institutional investors.
What are the tax implications of investing in corporate bonds?
Interest income from corporate bonds held in taxable accounts is subject to federal income tax and possibly state tax depending on your residency. The Tax Cuts and Jobs Act of 2017 also applies a special 3.8% Net Investment Income Tax on investment income above $200,000 of modified adjusted gross income for individuals. This extra 3.8% tax affects bond interest, capital gains, dividends, and other investment income.
However, the interest paid on municipal bonds issued by state and local governments is exempt from federal tax. Municipal bond interest may also be exempt from state and local income tax depending on the issuer’s location and the investor’s residency. These tax perks give “munis” lower yields than taxable bonds of similar quality. Consult a tax professional to determine your own situation.
What happens to bondholders when a company merges with or acquires another?
Most large M&A deals don’t directly affect existing corporate bondholders. Companies raise new financing for acquisitions rather than using current bonds. The target company’s bonds also typically remain outstanding as subsidiary debt until maturity or early redemption.
However, bond indentures contain change-in-control provisions protecting investors if an acquisition impairs credit strength. If the deal triggers a downgrade to below investment grade, bondholders can demand repayment at par value plus accrued interest. This gives investors reassurance that a merger won’t negate the value of their bond investment.
Do bondholders have any voting rights in the issuing company?
No, bondholders do not have voting rights in shareholder elections. Bondholders are creditors of the corporation while shareholders are part owners. Lacking voting power, bondholders must rely on contractual rights specified in indenture agreements and protective covenants. Rights may include requiring collateral, restricting additional debt burdens, and compelling repayment of principal upon adverse events like downgrades.
However, while rare, bondholder groups can exert influence on management decisions in times of financial distress. They may organize and negotiate collectively to improve prospects for repayment. But unlike shareholders, bondholders can’t directly vote to replace directors or influence routine business decisions.
How do I evaluate liquidity risk for a corporate bond investment?
The primary considerations are:
1) Issue size – Larger bond issues tend to be more liquid with greater trading volumes.
2) Age – Newly issued bonds have higher liquidity that declines over time. Bonds near maturity within 5 years become more liquid again.
3) Credit rating – Lower-rated bonds have lower liquidity on secondary markets. Investment-grade bonds are easier to trade.
4) Inclusion in an index – Bonds in major Bloomberg or ICE indexes have higher liquidity due to inclusion in ETFs and mutual funds tracking the benchmark.
5) Reputation of Issuer – Well-known public companies tend to have more actively traded bonds.
You can check current trading activity on the TRACE bond trading system at FINRA. Look for bonds averaging multiple trades per day without large spreads between bid and ask prices. Newly issued, investment grade, and benchmark index bonds from leading issuers offer the greatest liquidity and marketability.
How are convertible bonds valued compared to the underlying stock?
A convertible bond has a “conversion ratio” specifying how many shares it can convert into. The bond’s theoretical value is greater than its straight bond value or its conversion value. Bond value equals the present value of coupon interest payments plus face value at maturity. The conversion value is determined by multiplying the current share price by the conversion ratio.
If the stock price rises far above the conversion price, the conversion value exceeds the straight bond value. Bondholders would convert to realize stock gains instead of holding the bond. This conversion premium causes the bond’s market price to trend with the stock, trading at a premium to theoretical bond value alone. Investors are essentially paying for the option to convert and participate in the company’s equity upside.
Conclusion
Corporate bonds warrant inclusion in most diversified investment portfolios. Their relatively stable interest payments and higher yields versus government bonds help offset the volatility of stock holdings. Carefully selected investment grade issues allow conservative investors to generate income with reasonable default risks. Those who can tolerate higher risk may gravitate toward high-yield bonds for greater income potential.
However, corporate bonds come with more complexity in analysis and risks than passive fixed-income vehicles like bond index funds. Compare the pros and cons against your investment goals, time horizon, risk tolerance, and tax considerations before adding exposure. Treat corporate bonds as long-term holdings and maintain a cushion for share price fluctuations driven by economic and interest rate cycles. Their advantages are best captured by holding bonds to maturity rather than relying on market timing.
Reference
Moody’s Investors Service. “Annual US Corporate Default Study And Rating Transitions.” Moody’s, 2022, https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_1346021.
Standard & Poor’s. “2022 Annual Global Corporate Default And Rating Transition Study.” S&P Global Ratings, 2022, https://www.spglobal.com/ratings/en/research/articles/220303-2022-annual-global-corporate-default-and-rating-transition-study-12608901.
Thomson, James B. “Bonds: The Unbeaten Path to Secure Investment Growth.” Wiley, 2011.
Fabozzi, Frank J. “The Handbook of Fixed Income Securities.” McGraw-Hill Education, 2016.
Securities Industry and Financial Markets Association (SIFMA). “Fact Book 2022.” SIFMA, 2022, https://www.sifma.org/wp-content/uploads/2022/08/US-Fact-Book-2022-SIFMA.pdf.
Internal Revenue Service. “Tax Cuts and Jobs Act.” IRS, https://www.irs.gov/newsroom/tax-cuts-and-jobs-act.
Financial Industry Regulatory Authority. “TRACE Fact Book 2022.” FINRA, 2022, https://www.finra.org/filing-reporting/trace/trace-fact-book.