From plain vanilla to bells and whistles – corporate bonds run the gamut. Corporations can borrow cash from investors by issuing bonds when they need to raise money.
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 some potentially complex decisions.
Сorporations 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.
How does a corporate bond work?
Corporate bonds are debt obligations issued by a company to raise money. They offer higher rates of return because they are riskier than government bonds. But they are also stable, and as long as the issuing company stays in good shape, bonds typically hold up well in all economic conditions.
By purchasing corporate bonds, investors make a loan to the corporation issuing the bond. In exchange, the corporation agrees to pay interest on the principal and, in most situations, refund the principal when the bond matures or comes due.
Unlike equity stockholders, the bondholder doesn’t own any ownership rights in the company when they purchase a corporate bond. So no matter how profitable the firm gets or how high the stock price rises, you will only receive the interest and principal on the bond. Bondholders will, nevertheless, have a claim on the company’s assets and cash flows if it fails to make bond payments and files for bankruptcy.
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What are the types of corporate bonds?
Investors can choose from a wide variety of corporate bond kinds. Bonds can be classified by their maturity, their credit ratings, or according to the type of interest payments they offer.
Depending on the maturity bond range:
- Short-term notes (with maturities of up to five years)
- Medium-term notes (with maturities ranging between five and 12 years)
- Long-term bonds (with maturities greater than 12 years)
Bonds can be classified as investment or non-investment, depending on their credit ratings. Non-investment-grade bonds are less likely to be paid on time than investment-grade bonds. 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 crucial difference is this: While the value of investment-grade debt depends mostly on shifts in interest rates, the value of junk bonds depends mainly 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. Many institutional investors must 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
The type of interest payments that bonds offer is another way that they vary. Many bonds offer a fixed interest rate for the duration of their maturity. The interest rate is referred to as the coupon rate, and interest payments are referred to as coupon payments. When the coupon rate is fixed, it does not matter if the market interest rate fluctuates. Other bonds have floating rates that are recalculated regularly, like every six months. One type of bond makes no interest payments until the bond matures. These are called zero-coupon bonds. In this case, the bond is sold at a discount.
Other bonds, known as convertible bonds, allow investors to convert the bond into equity. They can also be secured or unsecured, senior or subordinated and issued out of different parts of the company’s capital structure.
What’s the risk of corporate bonds?
Corporate bonds 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 unique 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.
The market price of corporate bonds will typically increase as soon as interest rates start to decline. As well as the opposite result, Investors attempt to lock in the highest rates for the most prolonged period possible, which leads to this situation.
Bond payments depend on the issuer’s ability to generate cash flow. However, unexpected situations can occasionally arise for businesses, preventing them from generating cash flows. Sometimes, the ability to generate liquidity determines how much interest will be paid on the corporate bonds linked to the product.
The investor might lose their money and the chance to receive the intended interest payments if the company that issued the corporate bond goes out of business.
Why invest in corporate bonds?
Corporate bonds involve a lot of rewards.
Corporate bonds provide regular cash payments. The high returns that corporate bonds offer investors are one of their key benefits.
- By adding this option to their portfolios, investors can access various corporate bond types.
- Corporate bonds provide high levels of liquidity to investors. Most corporate bonds are tradable in the secondary market. In other words, after a company issues these securities, investors can buy or sell them.
- Corporate bonds tend to have better yields. Compared to government, municipal, or other types of bonds, corporate bonds carry a higher level of risk, but they have historically offered higher yields.
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 are sometimes 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. Some investors buy up defaulted bonds for pennies on the dollar, speculating on the eventual payout.
What is commercial paper?
Sometimes a company borrows money to finance a huge long-term project or a significant 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. In addition, 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 issued mainly 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 the issue and no more than nine months. However, unlike longer-term corporate debt, the commercial paper doesn’t have to be registered with the SEC. As a result, investors consider it very safe and highly liquid in both US and international markets. Unfortunately, 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 on short-term issues.
What are the disadvantages of corporate bonds?
Investors should keep in mind that a variety of risk factors can have an impact on returns when investing in corporate bonds. The first step in managing these risks is to understand them.
You need to keep an eye on your corporate bonds’ risk. Changes in the issuer’s creditworthiness should be closely monitored because less creditworthy issuers may be more likely to miss interest or principal payments. Corporate bonds are subject to credit risk. Investors buying individual bonds must analyze the company’s ability to repay the bond.
Bonds typically hold up in all economic conditions as long as the issuing company stays in good shape. The drawback is that this stability comes at the expense of lower long-term returns. Although investors can buy some corporate bonds for as little as $1,000, most investors need a lot more cash to participate in this asset allocation.
You need to be able to invest a bigger sum of money. Bonds have a slight chance of capital growth. The yield to maturity of a bond indicates how much you can expect to make from it. A stock, on the other hand, has the potential to increase for decades while earning much more than a bond.
What Are Corporate Bonds And How To Invest In It? by Inna Rosputnia
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