Corporate Bonds: What Are They and How Do They Work?
A corporate bond is a form of debt used by companies to fund their operations and expansion plans. Companies issue bonds to investors in exchange for a fixed rate of interest and return of the principal over a predetermined time period. Bonds are usually rated according to their perceived riskiness by credit rating agencies like Standard & Poor’s and Moody’s.
Investors can benefit from corporate bonds in several ways. Corporate bonds allow investors to diversify their portfolios and generate income via regular interest payments over the life of the bond. Bonds are also typically safer than stocks, which tends to make them suitable for more conservative investors.
Types of Corporate Bonds
There are several types of corporate bonds available to choose from, each with different features and risks. Below is a brief overview of the most popular types of corporate bonds:
• Investment-Grade Corporate Bonds: These bonds are secured by a “term sheet” and represent a low-risk method of investing in corporations. They are rated A or higher by Standard & Poor’s, which means they have a low probability of defaulting on their payments. Investment-grade bonds typically have lower yields than other types of bonds due to the lower risk associated with them.
• High Yield Corporate Bonds: These bonds are rated BB or lower by Standard & Poor’s and carry considerably more risk than investment-grade bonds. They may come with higher yields, but there is also the potential for greater losses for investors.
• Zero-Coupon Bonds: These bonds do not pay regular coupon payments to investors and instead pay the full face value of the bond at maturity. Investors can benefit from these as they come with discounted prices and the potential for greater returns if interest rates fall.
• Convertible Bonds: This type of bond gives investors the option to convert a traditional bond into stock upon maturity. They come with higher yields than investment-grade bonds, however, there is also the risk that investors will not be able to execute their conversion right when they are ready to.
• Perpetual Bonds: These bonds have no predetermined maturity date. Investors will receive interest payments, but won’t ever receive their principal back until the bond’s issuer decides to recall the loan. These bonds can also be refinanced, which means the company may not have to pay the full principal value back.
The Benefits & Risks of Investing in Corporate Bonds
The potential benefits of investing in corporate bonds include diversification, regular income and potential capital gains at maturity. There are, however, a number of risks associated with corporate bonds that all investors should consider before making an investment. Let’s have a closer look at these:
Benefits of Investing in Corporate Bonds
• Regular Income: Bonds offer investors regular coupon payments throughout their term as long as the company remains in good credit standing. This can be beneficial for investors who are looking for steady, regular income from their investments.
• Diversification: Corporate bonds can help diversify a portfolio that already includes stocks and mutual funds. This can be particularly beneficial for those who are looking to spread out the risk associated with their investments.
• Potential Capital Gains: Bonds are typically bought at a discounted rate, which means they may generate higher returns when they reach their maturity date. This can provide a nice capital gain for investors upon the maturity of their bonds.
Risks of Investing in Corporate Bonds
• Default Risk: This is perhaps the biggest risk associated with corporate bonds. Default risk is the possibility that the company issuing the bond will not be able to repay the money it has borrowed. Investors should always carefully research a company before investing in any of its bonds to make sure it has the capacity to repay its debt.
• Credit Rating Risk: Bond ratings given by rating agencies like Standard & Poor’s and Moody’s are used to measure the risk associated with corporate bonds. Lower-rated bonds inherently come with more risk, so investors should always research a company’s credit rating before investing in its bonds.
• Interest Rate Risk: When interest rates increase, the price of bonds tends to decrease. This can lead to capital losses for investors who are holding onto longer-term bonds in a rising interest rate environment.
• Liquidity Risk: Investors should also be aware of the potential liquidity risks associated with corporate bonds. Bonds have less liquidity than stocks, which means there may not always be a ready buyer when investors need to cash out of their investments.
Overall, corporate bonds can be a great way for investors to generate regular income and diversify their portfolios. Bonds come with their own set of risks, however, including default, credit rating and liquidity risks. Investors should always conduct thorough research before investing in corporate bonds to make sure they have a clear understanding of not just the potential rewards, but also the risks.
