What Are Corporate Bonds?
Corporations Are Issuing Bonds at a Record Clip
Companies issued more than $1.4 trillion in 2016, as of November. Companies want to issue debt at the record-low interest rates, thanks to expansionary monetary policy from the Federal Reserve. In total, there is more than $8 trillion in corporate debt outstanding.
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 relatively much easier and provides 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. That's because there is a greater chance the company can go bankrupt and default on the bond. That's why they are usually rated as 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.
However, 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 duration, or how long it will take for the bond to mature. There are three lengths of duration:
- Short-term (three years or less) - These used to be considered the safest, because they were held for less time. However, since the Fed has announced it will probably raise interest rates in 2015, these rates will probably also rise.
- Medium-term (four to 10 years) - Rates will probably rise on these bonds as well over the next year, as the Fed tapers off its purchases of Treasury notes. For more, see Quantitative Easing.
- Long-term (more than 10 years). Longer-term bonds usually offer higher interest rates because they 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 usually sold with a call, or redemption provision, that allows the issuing company to redeem them after the first 10 years (for a longer-duration bond) if interest rates are lower. That allows them to pay off your bond with funds from a new, cheaper bond. (Source: WSJ, More Ways Bond Can Bite You, May 5, 2014)
The second category is the risk.
- Investment grade bonds are issued by companies that are unlikely to default. Most corporate bonds are investment grade. They are attractive to investors who want more return than they can get with Treasury notes, and 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. However, that's because they are the riskiest. In fact, their rating should scare you -- "not investment grade." That means they are considered downright speculative. They are rated as B or lower. (Source: "Types of Corporate Bonds," HJ Sims.)
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, and 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, usually every six months. The payments will change based on the prevailing interest rates of U.S. Treasury notes.
- Zero coupon bonds withhold interest payments until maturity. However, the investor must pay taxes on the accrued value of the interest payment, just as if they were being paid. (Source: SEC, What Are Corporate Bonds.
- Convertible bonds are like plain vanilla bonds, but allow you to convert them to shares of stock. If stock prices rise, this will increase the value of the bonds. If stock prices fall, you still have the bond coupons and the original bond value if you hold until maturity. Since they have this added advantage, they typically pay lower interest rates than plain vanilla bonds.
What About Other Bonds?
- What Are Treasury Bills, Notes, and Bonds?
- What Are Savings Bonds?
- What Are I Bonds?
- What Are Municipal Bonds?