Corporate Bonds: Definition & Explanation
Corporate bonds are debt securities that many investors use to earn a return on their money. Unlike government bonds, corporates are issued by companies looking to raise capital. Whereas stocks are shares of an ownership stake in a company, companies that issue bonds do not have to give up any ownership shares.
One way to understand corporate bonds is to draw a distinction between them and stocks. We will look at these two types of financial instruments and draw out their differences. Then we will review some of the different types of bonds and their features.
Stocks vs. Bonds
Two of the most important ways companies raise capital is by issuing bonds or issuing shares of stock. Shares of stock are ownership shares of a firm. Investors purchase equities and earn returns either through dividend payments or through capital appreciation.
A bond is not an ownership share of a company – rather, it is a loan that an investor makes to the bond issuing firm. While dividend payments are not legally bound and rising stock prices are never certain, bond issuers are legally obligated to make the promised interest payments on their loan.
Not only are interest payments legally obligated for corporate bond issuers, but in the event of a bankruptcy, bondholders are legally required to be paid out for their bonds before any leftover money is distributed to equity holders.
As a result, corporate bonds are considered less risky than stocks. The result is increased safety in bonds but also a limit on how much investors can earn compared with stocks. Whether or not an investor should be heavier on bonds or stocks depends on their risk tolerance and the stage of their life that they’re in.
On the other hand, corporates are perceived to be riskier than government bonds because of the credit worthiness of the United States government. As a result, corporate bonds tend to pay higher interest than government bonds.
How Corporate Bonds Work
Bonds are generally issued in blocks of $1,000 par value. Sometimes, however, they are issued in blocks of $5,000 or $10,000. An investor buys the block or blocks and usually will receive interest payments throughout the life of the bond. The interest rate also helps determine the coupon payment.
When the bond matures, the investor receives the final coupon payment and the return of their original principal investment. That’s the termination of the debt and the company has no more payments to make.
Investors don’t have to hold the bond to maturity, of course. They can sell the bond on an exchange at any time during the life of the bond. Sometimes bonds will trade at a premium above par or at a discount below. This is determined by the coupon rate of the bond versus the behavior of interest rates on the market.
Fixed-rate bonds are the most common type. With fixed-rate corporate bonds, the issuing company pays the same interest rate each period without fluctuation. For example, if the coupon rate on a $1,000 par value bond is 6%, the issuer will pay a rate of $60 each year. This is derived by multiplying 6% by the $1,000 value. Also, the coupon payment is often spaced out in semiannual, quarterly or monthly payments.
Bonds generally fall into one of two categories: investment grade and noninvestment grade (high-yield or “junk” bonds). Bond ratings are determined usually by one of three ratings agencies: Moody’s, Fitch or Standard & Poor’s.
Investment-grade bonds are deemed to be financially healthier than the alternative. As a result, they are likely to be less risky and, therefore, generally pay lower interest rates than junk bonds. The opposite is true for high-yield bonds: they generally pay higher rates for the additional risk investors take on.
Types and Features of Corporate Bonds
There are a number of different types of corporate bonds that have different features. These include the following:
- Callable and Puttable Bonds – Call and put options on bonds allow either the bond issuer (callable bonds) or the investor (puttable bonds) to redeem the bonds before the date of maturity.
A company would want to exercise a call option if interest rates had significantly decreased so that it could issue newer, cheaper debt. An investor may want to put a bond back to the company if interest rates increase and they could earn higher interest on their investment elsewhere.
One example of a put option is known as the “Survivor’s Option.” With this option, if a bondholder dies, the heirs are allowed to put back the bond to the issuing company and can usually receive par value.
. - Zero-coupon Bonds – Zero-coupon bonds do not make coupon payments throughout the life of the bond. Instead, the bonds are initially sold at a discount to par value, and at maturity the investor is paid the full part value of the bond.
The prices of zero-coupon bonds generally have a higher amount of volatility than others that pay regular coupons.
. - Convertible Bonds – Convertible bonds are bonds that can be changed into a particular number of shares of common stock. Usually this can be done only at specified times. As a result, equity prices can affect the prices of convertible bonds.
Final Thoughts on Corporate Bonds
If you’re looking for some fixed income investments, corporate bonds can be a great choice. They enable you to diversify your overall portfolio and earn regular interest payments without taking on the risk of stocks. For more information on bond and income investing, as well as other investment opportunities, you’ll want to sign up for Investment U’s free daily e-letter today.
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