From plain vanilla to bells and whistles — corporate bonds run the gamut.

When corporations need to raise money, they can borrow the cash from investors by issuing bonds. There’s a substantial market for these bonds — as evidenced by the more than $8 trillion of corporate debt that’s currently outstanding. But investing in corporate bonds can require making a number of potentially complex decisions.

For starters, the companies that issue debt range from large, well-known blue chips to small, new startups that are privately held. What’s more, corporations can craft a bond to control the cost of borrowing and to encourage investors to purchase. As a result, two bond issues from the same corporation may be very different investments.

Corporate bonds also involve risks that don’t apply to government or agency bonds. Some of these risks are linked to the specific fortunes of a company, some to the state of the economy, and some to the special features of the bonds themselves. To make up for these added risks, corporate bonds generally pay higher interest rates than Treasurys or municipals with comparable maturities. But there’s a catch. The interest you earn from corporate bonds is taxed as ordinary income at federal, state, and local levels.

Benefits for institutional investors

Large institutional investors have advantages over individual investors in purchasing corporate bonds. That’s because institutional investors trade in larger lots — a minimum of $100,000 per transaction — so their markups tend to be lower. In addition, since broker-dealers cultivate institutional investors, they tend to give them preference on the most attractive bond offerings.

Defaulted bonds aren’t always worthless, since bondholders are fairly high on the priority list of who gets paid if a company emerges from bankruptcy or is reorganized. Bondholders may eventually get some, if not all, of their investment back. So some investors actually buy up defaulted bonds for pennies on the dollar, speculating on the eventual payout.

Understanding corporate bonds risks

Many institutional investors are required to limit their bond holdings to highly rated issues known as investment-grade bonds. So investment-grade pickings can be slim for individuals shopping for bonds, since the supply is limited. In the market of bonds that fall below investment grade, however, individual investors find more opportunities.

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These bonds — known as speculative grade, high yield, or less flatteringly as junk — carry a higher risk of default than investment-grade bonds, but they yield considerably more. Investing in high-yield bonds, however, requires a different strategy from investing in investment-grade bonds. The most important difference is this: While the value of investment-grade debt depends mostly on shifts in interest rates, the value of junk bonds depends mostly on the credit risk of the companies that issue them. As a result, junk-bond markets tend to act more like stock markets, rising and falling with company performance.

The paper route

Sometimes a company borrows money to finance a huge long-term project or a major expansion. Other times, they borrow to meet short-term book-keeping needs — for example, to keep up inventories and make provisions for the uncertain timing of accounts receivable. If the company has a high credit rating, it’s often cheaper and easier to borrow from investors than from a bank. This short-term, unsecured corporate debt is known as commercial paper.

It’s mostly issued by large financial companies, which need a lot of short-term loans to manage their cash flows. Like other short-term debt, the paper trades at a discount and pays par at maturity, which is usually around 30 days from issue and no more than nine months. Unlike longer-term corporate debt, the commercial paper doesn’t have to be registered with the SEC. Investors consider it very safe and highly liquid in both US and international markets. That low risk typically translates into low yield.

Who buys commercial paper? Mostly, other companies do. That’s because the paper comes in denominations of $100,000 and up — and sometimes over $1 million. Individual investors usually get exposure to commercial paper through money market funds, heavily in short-term issues.

What’s a REPO?

Repurchase agreements, better known as repos, are very short-term loans between financial institutions that help to keep markets liquid. What’s unique about a repo is that the firm initiating the deal borrows collateral, usually a US Treasury issue, and, using a bank as an intermediary, sells the collateral for cash, agreeing to buy it back at a slightly higher price, sometimes as quickly as the next day.

In a reverse repo, in contrast, an institution with excess cash may initiate an arrangement, agreeing to buy a security and sell it back in the future for a higher price. Repos are low-risk products but they aren’t risk free. A deal can fail if one of the counterparties fails to provide the required collateral. It can become more complicated if the value of the collateral changes, or if the collateral can’t be transferred easily between parties, which may occur in a cross-border transaction.

Got collateral?

Some corporate issuers back up their bonds with collateral, which can be liquidated to repay bondholders if the company should default. For example, collateral trust bonds are backed by securities, usually those issued by wholly-owned subsidiaries of the issuer. If a corporate bond has no collateral backing it up, it’s known as a debenture or note.

What Are Corporate Bonds And How To Invest In It? by Inna Rosputnia

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