Corporate Bonds, Types, and Market Size
Corporations are issuing bonds at a record clip
The alternative for companies is to engage in an initial public offering and raise equity by selling stocks. This is a long and expensive procedure. Selling bonds, while still complicated, is easier. It's a quicker way to raise capital for corporate expansion.
You can buy corporate bonds individually or through a bond fund from your financial adviser. They are less safe than government bonds. There is a greater chance the company can go bankrupt and default on the bond. They are rated according to their risk by Moody's or Standard & Poor's. The higher the risk, the higher the return the corporation must offer.
Corporate bonds, like all other bonds, offer a fixed interest rate to the bond purchaser. If you hold the bond to maturity, you will receive the principal plus the sum of all the interest paid. That's your total return or yield.
But if you sell the bond before maturity, you may not get the same price back that you paid for it. The value of your bond will drop if interest rates on other bonds go up. Why would someone pay you the same if your bond has a lower interest rate than the others that are available? In that case, your total return or yield will drop. That's why they always say bond yields fall when interest rates rise.
Types of Corporate Bonds
There are many different types of corporate bonds, depending on their risk and return.
The first category is the duration. This refers to how long it will take for the bond to mature. There are three lengths of duration:
- Short-term – Set to mature in three years or less, these bonds used to be considered the safest, because they were held for less time. But in 2015, the Fed began raising interest rates. That means some of those bonds will depreciate in value.
- Medium-term – Rates will probably rise on these bonds as well over the next year, as the Fed tapers off its purchases of U.S. Treasury notes. The term on these bonds is four to 10 years. The Fed purchases these when they see the need to stimulate the economy through quantitative easing.
- Long-term – Longer-term bonds, with terms of more than 10 years, offer higher interest rates because these tie up lenders’ money for a decade or more. This makes the yield, or overall return, more sensitive to interest rate movements. These bonds are sold with a call, or redemption provision. Longer-duration bonds allow the issuing company to redeem them after the first 10 years if interest rates are lower. That allows them to pay off your bond with funds from a new, cheaper bond.
The second category is the risk.
- Investment grade bonds are issued by companies that are unlikely to default. Most corporate bonds are investment grade. These are attractive to investors who want more return than they can get with Treasury notes. These corporate bonds are really still quite safe. These are rated at least Baa3 by Moody’s and at least BBB- by Standard & Poor’s and Fitch Ratings.
- High-yield bonds, also known as junk bonds, offer the highest return. But they are the riskiest. In fact, the rating of "not investment grade" should scare you. These are considered downright speculative. These bonds rate a B or lower.
The third category is the type of interest payment.
- Fixed rate, also called plain vanilla, are the most common. You will receive the same payment each month until maturity. These are called coupon payments. The interest rate is called the coupon rate. Back in the old days, investors actually had to clip the coupons on the paper bond and send them in to get paid. Now, of course, it's all done electronically.
- Floating rate bonds reset their payments periodically, every six months. The payments will change based on the prevailing interest rates of Treasurys.
- Zero coupon bonds withhold interest payments until maturity. The investor must pay taxes on the accrued value of the interest payment, just as if they were being paid.
- Convertible bonds are like plain vanilla bonds, but these allow you to convert them to shares of stock. If stock prices rise, the value of the bonds will increase. If stock prices fall, you still have the bond coupons and the original bond value if you hold until maturity. Since these bonds have this added advantage, these pay lower interest rates than plain vanilla bonds.