Bonds can make up an important part of a diversified portfolio, but you can find diversity within bonds as well. Corporate bonds are one type of debt security that may offer higher returns than government bonds, but they may also come with higher risk.
What Is a Corporate Bond?
A bond is a debt security that functions much like an IOU. Governments and companies issue these obligations as a way to raise capital. For example, a state might issue bonds to build a new bridge, and the U.S. Treasury issues Treasyry Bills (T-Bills) to cover its expenses.
Corporations also sell bonds to raise capital. They might use the money raised through the financial securities to reinvest in their business, pay down debts, or even buy other companies.
When investors buy corporate bonds, they are loaning a company money for a set period of time. In exchange, the company agrees to pay interest throughout the agreed upon period. When this time is up and the bond reaches “maturity” the issuer will return the principal. If a company can’t make interest payments or return the principal at the end of the period, they default on the bond.
How Do Corporate Bonds Work?
Bonds are a huge part of the broader securities markets. U.S. fixed income markets comprise nearly 40% of global securities. To understand bond market and how bonds work, you need to know a few important terms:
• Issuer: The entity using bonds to raise money.
• Par Value: Also known as the nominal or face value of the bond or the principal, the par value is the amount the bond issuers promise to repay when the bond reaches maturity. This amount does not fluctuate over the life of the bond.
• Price: A bond’s price is the amount an investor pays for a bond in the market. This amount can change based on market factors.
• Coupon rate: Also known as coupon yield, the coupon rate is the annual interest rate paid by the bond issuers based on the bond’s par value.
• Maturity: The date at which a bond’s issuer must repay the original bond value to the bondholder.
Benefits and Drawbacks of Corporate Bonds
While corporate bonds can add a lot of benefits to a portfolio, before investing it’s important to consider the drawbacks, as well.
|Bonds, including corporate bonds, can be an important part of a diversified portfolio.||Bonds may offer lower returns than other securities, such as stocks.|
|Many investors consider corporate bonds as a riskier investment than government bonds, such as U.S. Treasuries. As a result, they tend to offer higher interest rates.||If the issuer cannot make interest payments or repay the par value when the bond reaches maturity, the bond will go into default. If an issuer goes bankrupt, bondholders may have some claim on the company’s assets and be able to recoup some of their losses.|
|Bonds are relatively liquid, meaning it is easy to buy and sell them on the market.||Some bonds are “callable”, which means issuers can choose to pay them back early. When that happens, bond holders won’t earn as much interest and will have to find a new place to reinvest.|
Types of Corporate Bonds
There are three main ways to categorize corporate bonds:
This category reflects the bond’s maturity, which may range from one to 30 years. There are three maturity lengths:
• Short-term: Maturity of less than three years.
• Medium-term: Maturity of four to 10 years.
• Long-term: Maturity of more than 10 years. Longer-term bonds typically offer the highest interest rates.
Every once in a while, a corporation defaults its bonds. The likeliness of default impacts a company’s creditworthiness and investors should consider it before purchasing a bond. Bond ratings, assigned by credit rating agencies, can help investors understand this risk.
Bonds can be rated as:
• Investment grade: Companies and bonds rated investment grade are unlikely to default. High-rated corporate bonds typically pay a slightly higher rate than government securities.
• Non-investment grade: Non-investment grade bonds are more likely to default. Because they are riskier, non-investment grade bonds tend to offer a higher interest rate and are often known as high-yield bonds.
Investors may also categorize bonds based on the type of interest rate they offer.
• Fixed rate: With a fixed rate bond, the coupon rate stays the same over the life of the bond.
• Floating rate: Bonds that offer floating rates readjust interest rates periodically, such as every six months. The floating rate depends on market interest rates.
• Zero-coupon bonds: These bonds have no interest rate. Instead, when a bond reaches maturity, the issuer makes a single payment that’s higher than purchase price.
• Convertible bonds: Convertible bonds act like regular bonds with a coupon payment and a promise to repay the principal. However, they also give bondholders the option to convert their bonds into company stock according to a given ratio.
Difference Between Corporate Bonds and Stocks
Bonds differ from other types of investments in a number of important ways. When investors buy stocks, they are buying ownership shares in the company. Share prices may fluctuate depending on the markets and the health of the company. If the company does well, the stock price may rise, and the investor can sell their shares at a profit. Additionally, some companies share profits with their shareholders in the form of dividends.
When an investor purchases a corporate bond, on the other hand, they do not own a piece of the company. The bondholder is only entitled to interest and the principal. Those amounts don’t change based on company profits or the stock price. When a company goes bankrupt, bondholders have priority over stockholders when it comes to claims on the issuer’s assets.
How to Buy Corporate Bonds
Investors can buy individual bonds through brokerage firms or banks. Corporations typically issue them in increments of $1,000. Much like investing in an initial public offering, it can be tricky for retail investors to get in on newly issued bonds. Investors may need a relationship with the organization that’s managing the offering. However, investors can also purchase individual bonds on the secondary market.
Another way to gain access to the bond market is by purchasing bond funds, including mutual funds and exchange-traded funds that invest in bonds. These funds can be a good way to diversify a bond portfolio as they typically hold a diverse basket of bonds that tracks a bond index or a certain sector.
Investors can purchase bonds through a traditional brokerage account or an Individual Retirement Account. They may be able to purchase bond funds through their 401(k), and possibly individual bonds through a brokerage window within the 401(k).
Recommended: IRA vs 401(k) – What is the Difference?
More sophisticated traders may choose to invest in bond options, which allow them to bet on the direction in which a bond price may go without actually purchasing the bond itself.
Before buying bonds, it’s important that individuals consider how they’ll fit in with their financial goals, risk tolerance, and time horizon. For example, if you’re working toward retirement and have decades to save, you may want a portfolio that’s mostly stocks since stocks tend to outperform bonds in the long run. If you’re close to your goal — or have a low appetite for risk — you may want to stick with bonds.
Stocks are also typically more volatile, but those with a long time horizon may have ample time to ride out the ups and downs of the market. If you’re interested in using stocks to build your portfolio, a good way to start is by opening a brokerage account on the SoFi Invest® investment app.
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