The stock market crash of the late 2000s taught many investors a painful lesson about the importance of diversifying their investments. They remain committed to low- to moderate-risk investment vehicles that provide a compromise between security and return on investment.
Corporate bonds are one such vehicle. They can provide predictable interest payments for income-seeking investors at manageable risk levels. They occupy a middle ground between low-interest, low-risk government bonds and stocks, which may offer higher returns but are much riskier overall.
But corporate bonds are not perfect. Individual corporate bonds have significant drawbacks you should carefully consider before investing.
What Is a Corporate Bond?
Both private and public companies sell corporate bonds to raise money for business operations. In exchange, they pay you interest on the amount you purchased.
Motley Fool Stock Advisor recommendations have an average return of 618%. For $79 (or just $1.52 per week), join more than 1 million members and don’t miss their upcoming stock picks. 30 day money-back guarantee. Sign Up Now
Like other assets that pay interest, companies most often use corporate bonds to fund capital projects. This term encompasses just about any investment a company can make, such as:
- Construction of a new warehouse or manufacturing facility
- Purchasing or leasing new property
- Purchasing or leasing new equipment
- Buying inventory
They typically come in units that carry a face value of $1,000. Also known as “par value,” it’s the amount the company, known as the bond issuer, must pay the holder on the bond’s maturity date. Some bonds require investors to buy more than one unit, so they may have a minimum purchase amount, such as $3,000 or $5,000.
Corporate Bonds Structure
A corporate bond makes regular interest payments to its investors. It’s popular among income-seeking investors, from financial institutions looking to offset higher-risk investments to retirement investors trying to earn interest income over a set period.
Maturity Period & Call Date
Like a U.S. Treasury bond, a corporate bond has a specific maturity date. That’s the day you get the original amount of your investment back. Maturity terms on corporate bonds — the period between their issue date and maturity date — range from as short as one year to as long as 30 years.
Corporate bonds with less than one year maturity periods are known as “corporate paper” or “short-term financing.” The most common investors in these bonds are likely to be larger financial entities, including banks, mutual funds, and hedge funds rather than individual investors.
Many corporate bonds also have call dates. Call dates are the first date the issuing company can legally buy the bond back from investors if it no longer needs the money.
Prospectus
Before it issues a new bond to the general public, the company must release a prospectus that outlines the intended use of the money. This requirement applies even to private companies not listed on any stock exchange.
The prospectus describes the bond’s term, including its final maturity date and call date. It also outlines the bond’s initial interest rate and describes how and when the bond pays interest quarterly, semiannually, annually, or in a lump sum when the issuer buys the bond back.
Finally, the prospectus outlines the bondholder’s right of repayment if the issuing company defaults or declares bankruptcy. It includes the order in which investors receive repayment based on their investor type, which depends on whether the bond is secured or unsecured.
Secured vs. Unsecured Corporate Bonds
Corporate bonds can be secured or unsecured.
Secured bonds are guaranteed by some form of collateral, such as inventory, real property, or monetary assets. When a corporate bond issuer declares bankruptcy, secured bondholders have a legal right to seize the collateral.
Unsecured bonds, also known as debentures, are only guaranteed by the company’s promise to repay. Unsecured bondholders have no right to seize property. In the event of bankruptcy, they may be forced to forfeit future interest payments as well as a significant fraction of their principal payments.
Some bond types are always unsecured, such as convertible notes (which you can convert into shares of company stock). Others, such as fixed-rate and variable-rate bonds, may be either. You can find the bond’s secured status in the prospectus.
Because unsecured bonds are considered riskier for investors, they have higher interest rates than secured bonds. However, convertible bonds tend to come with lower interest rates because you can convert them into equity.
Corporate Bonds vs. Preferred Stocks
Corporate bonds share some features with preferred stock, such as regular payments to investors. These similarities are enough to create confusion for inexperienced investors.
But there are some important differences between the two as well:
- Debt vs. Equity. A corporate bond is a debt instrument that provides no ownership stake in its issuer. In contrast, a preferred stock is an equity vehicle that does confer ownership in the underlying company.
- Liquidity. You can trade both corporate bonds and preferred stock on secondary markets. But preferred stock often trades on stock exchanges, increasing the potential market size and making it easier for investors to buy and sell them.
- Repayment Order. In bankruptcy, preferred stockholders are entitled to repayment before common stockholders but after corporate bondholders.
- Exchange for Common Stock. You can exchange convertible corporate bonds for the issuers’ common shares under certain circumstances. Otherwise, it’s difficult or impossible for bondholders to exchange their holdings for stock. In contrast, you can always exchange preferred stocks for common stocks at an agreed-upon ratio.
Types of Corporate Bonds
Corporate bonds come in several different forms. A given bond can fall into more than one of these categories.
Fixed-Rate Bonds
This type of bond carries a fixed interest rate for its entire life. The rate is determined by its issuer’s credit rating on the bond’s issue date. Companies with higher credit ratings pay lower interest rates on their bonds, while companies with lower credit ratings pay higher interest rates.
Fixed-rate bonds typically make semiannual interest payments. They’re currently the most common type of corporate bond.
Variable-Rate Bonds
Variable-rate bonds’ interest rates change in response to fluctuations in long-term benchmark rates, with most bonds changing once per year. Their yield is generally determined by the company’s credit rating on the date of each interest payment.
Floating-Rate Bonds
Floating-rate bonds’ interest rates fluctuate with market benchmarks like Libor or the Federal Reserve’s federal funds rate and the company’s credit rating on the date of each readjustment. Unlike variable-rate bonds’ annual readjustments, changes in floating-rate bond rates usually occur after each quarterly interest payment.
Zero-Coupon Bonds
Zero-coupon bonds don’t pay interest. Instead, they trade at deep discounts to par value (face value). At maturity, the investor can redeem their zero-coupon bond for par value, realizing a profit over what they originally paid.
Callable Bonds
Issuers of callable bonds have the right to buy them back after an initial lockup period ends but before maturity. The first date the issuer can buy back the bond is known as the call date.
The buyback is always voluntary. For example, a company that issues a callable bond with a final maturity date of Jan. 31, 2030, and a call date of Jan. 31, 2024, can buy it back after the earlier of the two dates, but it doesn’t have to.
If a bond is called, its issuer typically pays par value and any unpaid accrued interest. Callable bonds can have fixed, variable, or floating rates.
A company may call bonds for various reasons. But most often, it’s because prevailing interest rates have fallen and the issuer’s credit allows it to secure lower rates on new debt issues.
Since called bonds are usually replaced with lower-yield bonds, an investor whose bond is called may have to settle for lower yields on future bond purchases that offer comparable levels of risk. They also miss out on future interest payments on the called bond. Both factors reduce their overall yield.
Putable Bond
Putable bonds, also called put bonds or retractable bonds, are the reverse of callable bonds. After a set date, holders of putable bonds are entitled to ask the issuer for repayment of their principal plus all accumulated interest.
It often occurs when a bondholder dies. Heirs of deceased bondholders may have a “survivor’s option” that entitles them to sell inherited bonds back to their issuers.
Bondholders may also exercise the put in inflationary environments. As prevailing interest rates rise, bonds with lower interest rates become less attractive, and their market value falls. It makes sense for bondholders to exercise the put sooner rather than later and use the proceeds to invest in bonds paying higher rates.
Because they give bondholders the right to early repayment, put bonds are less risky, more attractive investments. They typically have lower interest rates as a result.
Convertible
You can convert a convertible bond into a set amount of its issuer’s common stock. It allows a company’s creditor to secure an actual equity stake in it.
Like callable and putable bonds, convertible bonds come with restrictions on how and when you can convert to stock. They’re also more susceptible to issuers’ stock price fluctuations than other types of bonds.
Corporate Bond Ratings
Every corporate bond is rated by at least one of the major U.S. rating agencies — Fitch, Standard & Poor’s, or Moody’s. Each agency has its own letter-grade scale, but the most important distinction is between the two broad risk categories: investment grade and noninvestment grade.
Noninvestment-grade bonds are popularly known as “junk,” as in “junk bonds.” In more polite circles, they’re known as “high-yield bonds.” On S&P’s scale, which is the most commonly used measurement in the United States, all bonds rated below BBB- are considered noninvestment grade.
A bond’s yield is inversely proportional to its issuer’s credit rating. The higher the rating, the lower the yield.
Lower-rated bonds come with a higher risk of default. However, they also have high interest rates — far higher than investors could get in a savings account or CD. That’s worth the risk to some people.
Corporate bondholders do enjoy greater security than stockholders. Whereas a publicly traded company may suspend dividends on common or preferred stock at any time, any company that issues a corporate bond has a legal obligation to issue regular interest payments. The only ways out of it are to default on its bonds or declare bankruptcy.
How to Buy and Sell Corporate Bonds
Like common stock initial public offerings, institutional investors, brokers, fund managers, and individual professional investors tend to gobble up new bond issues. Although it’s possible for rank-and-file investors to purchase new corporate bonds on the primary market, it may require quick action due to issuers’ relatively short offering periods.
Fortunately, it’s easy enough to buy corporate bonds on the secondary market. All you need is a brokerage account that allows it.
If yours does, you should be able to search its database for thousands of publicly available coupons — from investment-grade bonds issued by blue-chip companies to junk bonds from less established companies.
If you want to own debt from a specific issuer, you can zero in on individual bonds. If you’re looking for bonds that fit more general yield, credit rating, or maturity criteria, customize your search to find them.
Buying Bonds on the Secondary Market
Most brokerages offer sophisticated search tools that let you search bonds by industry, minimum purchase amount, yield, issuer rating, and maturity date. Although no brokerage offers access to every corporate bond on the market, you can likely find a bond that suits your preferences.
Many online brokerages’ help sections offer guidance on the buying and selling process, but it’s not much more difficult than purchasing a regular stock.
On the secondary market, most corporate bonds are sold over the counter like OTC stocks. “Over the counter” just means you don’t buy them on a formal exchange.
Depending on prevailing interest rates, bonds sold on the secondary market may cost more or less than $1,000 per unit. On both the primary and secondary market, bonds may come with minimum purchase amounts of $5,000 — five units — or more.
You can’t buy all corporate bonds through a brokerage. Some are only available through mutual funds and exchange-traded funds, which are market-traded funds composed of stocks, bonds, commodities, or a mixture.
You can choose from various funds that focus on corporate bonds or include them as a component of their asset portfolios. The typical bond fund has dozens of individual bonds.
Since buying individual bonds is time-consuming and requires considerable capital, it often makes more sense for individual investors to purchase bond funds. But before investing, read each fund’s prospectus to determine what’s currently in it and what might be added to it in the future.
Pros and Cons of Corporate Bonds
Corporate bonds appeal to many different types of investors, but they have their downsides as well. Before investing, familiarize yourself with the pros and cons.
Pros of Corporate Bonds
Corporate bonds offer relatively high and predictable returns across a broad risk-reward spectrum. They’re reasonably likely to be at least partly repaid in bankruptcy as well.
- Higher Rates of Return Than Government Debt. Corporate bonds carry higher yields than government-backed bonds with the same term lengths. That includes inflation-protected bonds like Series I savings bonds.
- Relatively Predictable Returns. Corporate bonds are generally less volatile and pay more predictable returns than dividend-paying stocks — even low-volatility, high-yield blue chips and utility stocks.
- Purchasing Flexibility. You don’t have to buy corporate bonds in large chunks. You can purchase units of bond-heavy mutual funds and exchange-traded funds for less than the $1,000 cost of a single bond.
- Prioritized Repayments in Bankruptcy. Even if your corporate bond isn’t secured by collateral, its issuer must still prioritize the repayment of its principal and interest over that of any preferred or common stocks it issues. That means the company’s stock could drop to zero and you could still get some of your money back.
- Choice in Levels of Risk and Reward. If you invest in a bond with a C rating from S&P, you can look forward to double-digit returns. In return, you accept a real likelihood that if the issuer defaults or enters bankruptcy, you’ll receive less than you paid. But a bond with a AAA rating pays lower returns with a better chance of full repayment.
Cons of Corporate Bonds
For all their benefits, corporate bonds still have some significant downsides that could make them less attractive to certain investors.
- Limited Market Availability. You can’t buy all corporate bonds through a brokerage. That reduces liquidity and magnifies discrepancies between the price buyers are willing to pay and the price sellers are willing to accept for bonds.
- Some Bonds Are Difficult to Find. It’s technically possible to locate specific bonds, but it’s impractical for regular investors, and you may not find what you’re looking for. Buying into a bond fund often makes more sense.
- Regular Investors Have Inconsistent Access to the Primary Market. Regular investors face an uphill climb on the primary market, which professionals dominate. That’s a problem because bonds often cost more on the secondary market, reducing effective yield.
- Call Risk. If the issuer calls your bond, you make less money than anticipated and may have no option but to replace it with a lower-yield investment.
- Risk of Interest Rate Changes. If prevailing interest rates fall, floating- and variable-rate bondholders may receive smaller interest payouts, making it difficult to unload them and reallocate capital to more lucrative investments. If interest rates rise, fixed-rate bondholders have the same problem. Both may have to sell for less than they paid.
- Susceptibility to Inflation. While prevailing interest rates on new bond issues tend to rise with heightened inflation, long-term, fixed-rate bondholders who bought when inflation was tame don’t benefit. To hedge against inflation, invest in variable-rate corporate bonds or inflation-protected securities like Series I savings bonds. Or diversify your portfolio with assets that tend to beat inflation, such as common stocks and real estate.
- Potential Loss of Principal. It’s rare for corporate bondholders to be completely wiped out, but it’s possible to take losses of 50% due to corporate bankruptcy or default. If you can’t stomach the real risk, look to even more secure government-backed bonds.
Corporate Bond FAQs
Get all the answers to your questions about corporate bonds before investing.
What Happens If a Company Goes Bankrupt?
In short, corporate bondholders face the very real possibility of getting less than they paid for their bonds — sometimes, much less. In bond-speak, it’s known as a “haircut,” and you can expect it when a bond issuer declares bankruptcy.
Secured bondholders have more protection than unsecured bondholders. In some cases, they get all their money back even if unsecured bondholders lose much of their investment.
What’s the Difference Between Corporate Bonds & Stocks?
Corporate bonds aren’t as liquid as stocks. You can buy and sell them on the secondary market, but not as easily as you can buy or sell shares of big companies like Walmart, Apple, or Ford.
On the other hand, most corporate bonds pay regular interest rates or have built-in guarantees that they’ll deliver some sort of return to the holder. Stocks that don’t pay dividends make no such guarantees, and even dividend stocks can stop making payments to shareholders if the company’s financial condition worsens.
What Happens to Corporate Bonds When Interest Rates Rise?
Prices of existing bonds tend to fall when prevailing interest rates rise. That’s because bondholders know they can earn higher interest rates on new bonds issued at those higher rates.
What Is a High-Yield Corporate Bond?
A high-yield corporate bond is a polite term for a “junk bond,” which is a bond that rating agencies believe has a relatively high likelihood of default. Although they offer high returns, high-yield corporate bonds are risky investments.
Bonds with ratings below BBB- on the S&P scale are junk bonds. Bond funds generally won’t touch them, and regular investors should exercise caution.
What Happens When a Corporate Bond Matures?
A corporate bond’s maturity date is the date the issuer has to pay back its face value plus any unpaid accrued interest. If you hold a bond at maturity, you receive a cash payment you can spend or reinvest as you see fit, and neither you nor the issuer have any further obligations to one another.
Final Word
Corporate bonds offer predictable returns, manageable risk, and the backing of reputable corporations. Additionally, some of the most significant drawbacks of the corporate bond market have greatly diminished in recent years. These include inconsistent access to new issues and a lack of liquidity for some bonds on the secondary market.
That said, corporate bonds may not be suitable for investors with very low or very high appetites for risk or those who want to buy and sell freely. If you’re in either camp, you may be better served by preferred stocks.