Selling stock shares isn’t the only way corporations raise money. They can also issue corporate bonds, a type of debt security that promises to repay investors in full, with interest, over a specific period of time.
But what are the risks involved in throwing your hard-earned money into corporate bonds? Let’s dive in.
What Are Corporate Bonds?
Corporate bonds are essentially a way for companies to raise capital. Investors lend the company money and then that money is paid back to the investors at maturity. The company pays interest on the bond’s principal which allows the investor to earn money on their investment in the bond.
For example, let’s say a corporation issues five-year bonds today for $100 with an annual 5% fixed interest rate, called the coupon rate. You pay $100 for the issue, and you’ll get paid $5 each year for the next five years. You’ll get your $100 back at the end of the fifth year, when the bond matures, and you earned $25 for letting the corporation hold your $100 for five years.
You can buy corporate bonds through a broker or on a secondary market. When sold on secondary markets, a bond's value can fluctuate according to what’s going on in the market.
You can also invest in corporate bonds through bond funds, where professional investors buy and sell corporate bonds with your money in exchange for a small fee.
Corporate bonds can have fixed or variable interest rates, and may make coupon rate payments once or multiple times each year.
Bonds can also be classified based on their maturity: short-term (for less than three years), medium-term (four to 10 years), or long-term (longer than 10 years). Typically, longer-term bonds offer higher interest rates but also entail higher risk.
Risks of Corporate Bonds
Corporate bonds may sound like a pretty good deal for money that would otherwise sit in your bank account, but there are risks involved.
Ryan Lewis, an assistant professor of finance at the University of Colorado Boulder, told The Balance that, although there’s certainly risk involved, the corporate bond market isn’t considered as risky as the stock market.
“Corporate bonds offer something in between the risk-return profile of an equity, which is generally more risky, and Treasury bonds, which are super safe,” Lewis said in a video call interview.
Interest Rate Risk
Interest rate risk, also called market risk, comes into play when you’re buying or selling corporate bonds on a secondary market. Before the bond reaches maturity, its value in the market changes. As interest rates increase, a bond’s value decreases, and vice versa. A bond’s maturity and coupon rate affect its interest rate risk.
You avoid market risk when you hold corporate bonds from the issuance date until they mature. If you sell early, you risk losing money on your investment because of declines in value.
Corporate bonds with short maturities or high coupons are seen as having low interest rate risk. The opposite is true for corporate bonds with long maturities or low coupons.
To understand the impact of interest rate risk on coupons, consider an example of two bonds. One bond has a 2% coupon rate and the other has a 5% coupon rate. Assuming all other factors and features of the two bonds are the same, if interest rates rise, then the price of the 2% coupon rate bond will fall by a greater percentage than that of the bond with the 5% coupon rate.
This illustrates the risk investors should consider while purchasing bonds in a low interest rate environment.
Massi De Santis, a certified financial planner (CFP) and founder of DESMO Wealth Advisors, told The Balance in a phone interview that you should match the bonds you’re investing in with your financial goals, such as retirement, which is a long-term goal.
“You could take a little longer-maturity bond, and you could take a little more risk,” De Santis said.
Sometimes, corporations default on their outstanding bonds or interest payments because they don’t have the money to repay the debt. Credit risk, also called default risk, is the risk that the issuing corporation can’t repay its entire bond debt. You’ll lose either some or all of your original investment, depending on the situation.
Credit rating agencies like Moody’s and S&P Global Ratings signpost a corporate bond’s credit riskiness using scales.
Bonds with AAA, AA, or A ratings are called investment-grade and are considered a low credit risk. Lower ratings imply that the bond is speculative-grade and is more likely to default.
The bond market isn’t like the stock market. It’s not as liquid, meaning it’s tougher to trade them quickly.
The COVID-19 pandemic sent the corporate bond market into a liquidity crisis in March 2020, according to a joint analysis by researchers at the Federal Reserve of Philadelphia, the University of Illinois, and the University of California at Los Angeles. The Federal Reserve's intervention brought prices and yields back relatively quickly, but there was a short time where it was especially difficult for investors to sell their corporate bonds.
Corporate Bonds vs. Corporate Bond Funds
|Corporate Bonds||Corporate Bond Funds|
|Requires going through a broker||May be able to invest on your own through a brokerage account or directly with a fund company|
|Must choose specific bonds to invest in||Automatically invests in several bonds which allows for diversification|
|Expenses and fees may be higher||Expenses and fees may be lower|
While there are pros and cons of investing in either, experts agree that bond funds are the way to go for individuals looking to get into the corporate bond market instead of buying bonds directly.
Buying corporate bonds requires going through brokers, who will almost certainly charge more than a bond fund’s management fees, De Santis said. However, investors in bond funds would also need to watch out for expenses and fees.
Charlie Ripley, vice president for capital markets and trading at Allianz Investment Management, told The Balance in a phone interview that ETFs and bond funds may better suit individual investors because they’re inherently more diversified than hand-picking just a few corporate bonds.
“An ETF is going to be a basket of underlying bonds,” Ripley said. “So what you're going to have is exposure to a more diversified broad set of companies.”
For example, iShares Broad USD Investment Grade Corporate Bond ETF comes with a 0.04% expense ratio. With an average return of 6.4% over five years, it’s a low-cost and low-risk way to boost your portfolio.
But corporate bond funds face some of the same market risks as bonds themselves since they often trade the underlying bonds, not holding them until maturity. There is a chance that those transactions result in a capital gain or loss.
Simply put, investors may stand to lose some or all of their investment in a bond fund.
The Bottom Line
Corporate bonds carry risk—just like virtually any investment—but they can help diversify a portfolio of volatile, riskier stocks. Putting money in investment-grade, short-term bonds, especially as retirement draws closer, may help individuals maintain their wealth.
“As you approach retirement, you want safer assets,” Lewis said. “You want to be sure that you can access that capital.”
Take the time to learn how corporate bonds perform and whether investing in them aligns with your financial goals and risk tolerance.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.