Since March of 2009, the stock market has been on a tear. All three major U.S. indices have at least doubled their value, and retirement investors – not to mention those who make their living off the market – are breathing a long, collective sigh of relief. On paper, much of the damage of the late-2000s financial crisis has been undone.
However, many investors learned the hard way the value of diversifying their portfolio with low-to-moderate risk investment vehicles that provide an compromise between security and return on investment, or ROI.
Corporate bonds can provide predictable interest payments for income-seeking investors, as well as manageable levels of risk. However, they carry some drawbacks that you should carefully consider before investing.
The Basics of Corporate Bonds
Corporate bonds are debt vehicles issued by corporations. They can be issued by publicly listed companies, as well as by privately held firms. Like other debt securities, corporate bonds are issued to fund capital projects, such as the construction of a new warehouse or manufacturing facility, or purchases of new property, equipment, or inventory. They’re typically issued in units that carry a face value, also known as par, of $1,000.
The face value is the amount that the bond issuer is obligated to pay the holder on the bond’s maturity date. However, some bonds may have a minimum purchase amount of $5,000 or $10,000.
Since bonds are a debt instrument, they make regular interest payments to investors who purchase them. Like Treasury bonds, corporate bonds come with specific maturity dates, upon which the company repays the bondholder’s principal and all outstanding interest.
Maturity terms on corporate bonds range from as short as one year to as long as 30 years. Bonds with maturity windows of less than one year are known as corporate paper or short-term financing, and are more likely to be held by larger financial entities, including banks, mutual funds, and hedge funds, rather than individual investors. Corporate bonds are a popular instrument for income-seeking investors, from financial institutions that wish to offset higher-risk investments to retirement investors who wish to earn interest income over a set period of time.
Before it issues a new bond to the general public, a company – whether it’s privately held or listed on a stock exchange – is required to release a prospectus that outlines the intended use of the money. The prospectus describes the bond’s term, including its final maturity date and call date – the first date at which its issuer can buy it back. It also outlines the bond’s initial interest rate, which is higher than rates on government bonds with identical term lengths. And the prospectus describes how and when the bond’s interest is paid – whether it’s disbursed quarterly, semiannually, annually, or in a lump sum when the issuer buys back the bond.
Finally, the prospectus outlines the bondholder’s right of repayment in the event of default or bankruptcy. Holders of secured corporate bonds, which are directly tied to physical assets such as real property or equipment, are among the first creditors to be repaid in bankruptcy or default. Holders of unsecured bonds, which are merely guaranteed by the issuer’s promise to repay the investment, are repaid only after all secured creditors have been satisfied.
Types of Corporate Bonds
Unlike common stock, corporate bonds confer no ownership rights of the underlying company. When you purchase a corporate bond, you become a creditor of the firm that issued it. These bonds come in several different forms:
- Fixed Rate: This type of bond carries a fixed interest rate (determined by its issuer’s credit rating on the bond’s issue date) for its entire life. Fixed rate bonds typically make semiannual interest payments. They’re currently the most common type of corporate bond.
- Variable Rate: These instruments’ rates change in response to fluctuations in long-term benchmark rates, with most bonds changing once per year. Their yield is generally determined by the company’s credit rating on the date of each interest payment.
- Floating Rate: Floating rate bonds’ interest rates fluctuate in accordance with market benchmarks such as Libor or the Federal Reserve’s federal funds rate, and is also determined by the company’s credit rating on the date of each readjustment. Unlike variable rate bonds’ annual readjustments, floating rate bonds’ changes usually occur after each quarterly interest payment.
- Zero Coupon: These bonds accumulate interest at quarterly, semiannual, or annual intervals, but they don’t pay it out until their maturity or call date. Their rates are determined by their issuers’ credit ratings on the date of issue.
- Callable: Issuers of callable bonds have the right to buy them back from their holders during a period of time or after a predetermined date. For instance, a callable bond with a final maturity date of January 31, 2028 and a call date of January 31, 2020 can – but doesn’t have to – be bought back after the latter date. If a bond is called, its issuer typically pays par value – $1,000 per unit – and any unpaid, accrued interest.
- Puttable: After a set date, holders of puttable bonds are entitled to ask the issuer for repayment of their principal plus all accumulated interest. This often occurs when a bondholder passes away – heirs of deceased bondholders may have a “survivor’s option” that entitles them to sell inherited bonds back to their issuers.
- Convertible: A convertible bond may be converted into a set amount of its issuer’s common stock. This allows a company’s creditor to secure an actual equity stake in it. Like callable and puttable ponds, convertible bonds come with restrictions on how and when a conversion can occur. They’re also more susceptible to issuers’ stock-price fluctuations than other types of bonds.
Credit Ratings on Corporate Bonds
Corporate bonds are lumped into two broad categories: investment grade and non-investment grade (the latter is colloquially referred to as “junk” status). On S&P’s scale, which is the most commonly used measurement in the United States, all bonds rated below BBB- are considered speculative or non-investment grade. A company’s credit rating can fluctuate over time in response to changes in its perceived ability to repay its bondholders.
A bond’s yield is inversely proportional to its issuer’s credit rating – the higher the rating, the lower the yield – and lower-rated bonds come with a higher risk of default. However, it’s important to note that corporate bondholders enjoy greater security than stockholders. Whereas a publicly traded company may suspend dividends on common or preferred stock at any time, any company that issues a corporate bond has a legal obligation to issue regular interest payments. The only ways in which a company can evade this responsibility – and potentially stiff its bondholders – is to default on its bonds or declare bankruptcy.
Secured vs. Unsecured
Corporate bonds can be secured or unsecured. Secured bonds are guaranteed by some form of collateral, such as inventory, real property or monetary assets. Unsecured bonds, also known as debentures, are only guaranteed by the company’s promise to repay. Some types of bonds, such as convertible notes, are always unsecured. Others, such as fixed rate and variable rate bonds, may be either. A bond’s status is outlined in its prospectus.
When a corporate bond issuer declares bankruptcy, secured bondholders have a legal right to seize the agreed-upon collateral. Unsecured bondholders have no such right; in the event of bankruptcy, they may be forced to forfeit future interest payments, as well as a large fraction of their principal payments. Unsecured bonds generally compensate for this increased risk by offering higher interest rates. However, convertible bonds tend to come with lower interest rates because they can be converted into equity.
How to Buy and Sell Corporate Bonds
To buy corporate bonds directly, all you need is a brokerage account. Brokerage firms maintain databases of tens of thousands of publicly available corporate bonds available on the secondary market (available after original issue), from investment-grade bonds issued by blue chip companies, to junk bonds from less established companies that trade over the counter. Most brokerages offer sophisticated search tools that let you search these bonds by industry, minimum purchase amount, yield, issuer rating, and maturity date. Although no brokerage offers access to every corporate bond on the market, it’s likely that you’ll find a bond that suits your preferences in a major brokerage’s database.
Many online brokerages’ help sections offer guidance on the actual buying and selling process, but it’s not much more difficult than purchasing a regular stock. All newly issued corporate bonds come with per-unit values – also known as face or par values – of $1,000. A newly issued bond can be purchased through its underwriter, which is the investment bank that facilitates the issuer’s debt offering. Meanwhile, older bonds can be purchased on the secondary market. On the secondary market, most corporate bonds are sold over the counter, in a manner similar to OTC stocks. Depending on prevailing interest rates, bonds sold on the secondary market may cost more or less than $1,000 per unit. On both the primary and secondary market, bonds may come with minimum purchase amounts of $5,000 – five units – or more.
It’s also possible to purchase corporate bonds through mutual funds and exchange-traded funds (ETFs), which are market-traded funds comprised of stocks, bonds, and/or commodities. You can choose from a variety of mutual and exchange traded funds that focus on corporate bonds, or at least include them as a component of their asset portfolios. Before investing, read each fund’s prospectus to determine what’s currently in it – and what might be added to it in the future.
How Do Corporate Bonds Differ From Preferred Stocks?
There are similarities between bonds and preferred stocks which can create confusion for potential investors. Whereas a corporate bond is a debt instrument that provides no ownership stake in its issuer, a preferred stock is an equity vehicle that does confer ownership in the underlying company. Like common stocks, preferred stocks are denoted by ticker symbols and typically trade on stock exchanges. As such, they are usually more liquid than corporate bonds.
Whereas corporate bonds pay interest, preferred stocks pay regular dividends that can be reinvested in additional shares. There is no such reinvestment facility for corporate bonds. Preferred stockholders are entitled to repayment before common stock holders, but after corporate bondholders, in the event that the issuing company declares bankruptcy. Although convertible corporate bonds can be exchanged for their issuers’ common shares under certain circumstances, preferred stocks can always be exchanged for common stocks at an agreed-upon ratio.
Advantages of Corporate Bonds
- Higher Rates of Return Than Government Debt. Corporate bonds carry higher yields than government-backed bonds, including inflation-protected bonds such as Series I savings bonds, with equivalent term lengths. For instance, a 10-year Treasury bond might yield 2.7%, and Series I bonds 1.4%. By comparison, the average yield on AAA corporate bonds – S&P’s highest rating – might be 3.12%. BBB bonds, which are lower-grade (but still investment-quality), would have a slightly higher yield. In this example, they might average 3.72%.
- Relatively Predictable Returns. Corporate bonds generally experience less volatility and pay more predictable returns than dividend-paying stocks – even low-volatility, high-yield blue chips and utility stocks. Whereas companies can suspend dividend payments to stock holders at any time, they are legally obligated to make regular interest payments to their bondholders.
- Purchasing Flexibility. Corporate bonds don’t have to be purchased in large chunks. Many mutual funds and ETFs are partially or wholly comprised of these instruments, and it’s possible to purchase units of such funds for less than the $1,000 cost of a single bond. If you want to diversify with multiple bond holdings, but can’t afford to purchase 10 corporate bonds at $1,000 apiece, it makes sense to invest in a bond fund that could hold 10, 20, 30, or more bonds at any given time.
- Prioritized Repayments in Case of Bankruptcy. Even if your corporate bond isn’t secured by collateral, its issuer must still prioritize the repayment of its principal and interest over that of any preferred or common stocks that it issues. Even if a company’s common stock drops to zero, you could avoid a total loss on its bonds.
- Varying Levels of Risk and Reward. Credit rating agencies such as S&P and Moody’s assign letter-grade ratings to all corporate bonds on the basis of the risk that they pose to bondholders, which in turn can provide a framework through which to judge a bond’s risk-reward balance. But keep in mind that ratings are far from perfect and should be used cautiously – for instance, overly optimistic ratings for junk-riddled mortgage-backed securities directly contributed to the prolonged recession of the late 2000s. Relatively speaking, however, if you invest in a bond with a C rating (S&P’s lowest non-default rating), you may enjoy double-digit returns on your investment. In return, you accept a real likelihood that if the issuer defaults or enters bankruptcy, you’ll receive less than what you paid for the bond. If you invest in a bond with an AAA rating, you accept relatively low returns in exchange for more likely repayment.
Disadvantages of Corporate Bonds
- Lack of Market Availability. Not every corporate bond is available for purchase through a brokerage. Some bonds are only available as part of a bond fund, and others may be issued in such small amounts that there’s effectively no secondary market for them. This reduces liquidity and magnifies discrepancies between buyers’ bidding prices and sellers’ asking prices. Additionally, most bonds – especially those issued by international companies – aren’t listed on any financial exchange. Instead, they’re sold over-the-counter, either as new issues or on the secondary market. Since every corporate bond has a unique CUSIP ID, it’s technically possible to locate specific bonds. This is useful if you want to own debt issued by a specific company, with a specific maturity date. It can also help you find multiple bonds, each with different maturity dates and yields, from the same issuer. However, this is impractical for regular investors. Since bond funds contain dozens of different bonds with varying yields and maturities – and are often more liquid than individual bonds – it may make more sense for regular investors to purchase bond funds or ETFs.
- Regular Investors Have Inconsistent Access to the Primary Market. Like common stock IPOs, new bond issues are monopolized by institutional investors, brokers, fund managers, and seasoned individual investors. Although it’s possible for rank-and-file investors to purchase new corporate bonds – major brokerages like Fidelity offer programs that allow accountholders to purchase new issues – this may require quick action due to issuers’ relatively short offering periods. Additionally, individual brokerages’ offerings may be spotty, for reasons beyond investors’ (or brokerages’) control. For instance, Fidelity currently offers access to just eight new corporate bond issues, all of whose offering periods expire within days. Once a bond issue has been completed, many bonds are made available for resale by brokerages and fund managers, or incorporated into bond funds that individual investors can tap. However, bonds’ prices fluctuate on the open market, and if the market price of a bond with a $1,000-per-unit face value spikes to $1,050 per unit after its primary issue, an investor who purchases it on the secondary market starts off with a $50 loss.
- Call Risk. Some, but not all, corporate bonds are eligible to be called by their issuers. When a bond is called, the issuer immediately buys the bond back from its holder. Bonds may be called for a variety of reasons, but most often it’s because prevailing interest rates have fallen and the issuer’s credit allows it to secure lower interest rates on new debt issues. Since called bonds are usually replaced with lower-yield bonds – and bonds tend to be called during periods of falling interest rates – an investor whose bond is called may have to settle for lower yields on future bond purchases that offer comparable levels of risk. Furthermore, a bondholder who purchases his or her bond on the open market may pay more than $1,000 per unit. If his or her issuer calls the bond shortly thereafter, he or she will take a loss on the transaction. Even if he or she can earn enough interest to recoup the initial investment, the overall return on the holding is likely smaller than if he or she had purchased a similar bond that wasn’t callable.
- Risk of Changes to Interest Rates and Market Price. If prevailing interest rates fall, holders of floating and variable rate bonds may receive smaller interest payouts. Accordingly, investors may find it difficult to unload these holdings in a falling interest rate environment. This makes it harder to reallocate bond-tied assets to more lucrative investments such as common stocks. If interest rates rise, holders of fixed bonds may likewise find it difficult to unload their holdings. The reality is they’ll have to sell bonds at a discount (less than par).
- Susceptibility to Inflation Pressure. Like some other interest-bearing securities, including T-bills, corporate bonds lack built-in protection against inflation. While prevailing interest rates on new bond issues tend to rise during periods of heightened inflation, this does no good for holders of long-term, fixed-rate bonds who bought when inflation was tame. If you suspect that higher inflation is around the corner, consider investing in variable-rate corporate bonds or inflation-protected securities such as Series I savings bonds, or diversify your portfolio with securities that tend to beat inflation, such as common stocks and real estate.
- Potential Loss of Principal. Like all investments, corporate bonds carry the risk of partial or full loss of principal. While it’s rare for corporate bondholders to be completely wiped out, it’s possible for investors to take losses of 50% or more in the event of corporate bankruptcy or default. If you can’t stomach the small but real risk of taking a loss on your investment, look to even more secure government-backed bonds.
Corporate bonds offer predictable returns, manageable risk, and the backing of reputable corporations. Additionally, some of the biggest drawbacks of the corporate bond market – for instance, inconsistent access to new issues and a lack of liquidity for some bonds on the secondary market – have greatly diminished in recent years. That said, corporate bonds may not be suitable for investors with very low or very high appetites for risk, and those who wish to maximize the liquidity of their fixed-return securities may be better served by preferred stocks.
Do you own any corporate bonds? Do you appreciate their predictable returns, or do you prefer higher-risk, higher-reward investments?