Corporate bonds work in much the same way as U.S. Treasuries and municipal bonds. Corporations issue bonds in order to finance capital projects, purchases, or to raise cash. The bonds can be short-term, with maturity dates that are 12 months or less, or they can be long-term, with maturity dates longer than 12 months. Corporate bonds can make semi-annual payments or they can be zero-coupon.
But one critical difference exists between government issued and corporate issued bonds: The federal government can meet its debt obligations by printing money or increasing taxes. State and local governments can't print money, but they can almost always raise taxes. Corporations can do neither. Therefore, even a corporation with the highest credit rating and a stellar interest and principal payment history can run the risk of defaulting on the bonds it has issued. This fact makes corporate bonds inherently more risky, but this is risk is counter-balanced generally higher rates of return.
Bond Terms and Payment Structures
Corporate bonds are divided into three terms, or dates to maturity. The short-term category includes notes that mature in five years or less. Medium-term notes and bonds mature between five and 12 years, and long-term bonds have a maturity date of more than 12 years in the future.
The structure of a bond refers to payments you'll receive in exchange for loaning the corporation money. If the bond pays a fixed rate, the corporation will make regularly scheduled payments at regular intervals. If it pays a floating rate, the amount of the interest payments will vary. The amount of the payment is indexed to Treasury Bills and money market funds. Bonds that pay a floating rate protect investors against an increase in interest rates, as the payments will increase if interest rates rise. However, the yields are often lower than bonds that pay a fixed rate.
Finally, a corporation that issues a zero-coupon bond does not make regular interest payments. Rather, it will sell the bond at a discount to its face value and pay the investor the full face value at maturity.
Choosing the proper term and structure are paramount when buying corporate bonds. While these two factors are common to both corporate and government issued bonds, corporate bonds are much more likely to experience dramatic swings in prices and interest payments. In other words, corporate bonds are more volatile. It's highly improbable that the United States government will go out of business in the next five years. But even an established corporation with an excellent credit history can default. Adverse economic conditions, natural disasters, or changes in government policy can cause even the healthiest of businesses to shutter their doors. In general, corporate bonds with longer terms will return more than bonds with shorter terms.
The Relationship between Bond Ratings and Yields
All corporations that issue bonds are assigned a credit rating by the major credit rating agencies, including Moody's, Standard and Poor's, A.M. Best, and Fitch. The level of the credit rating is based on a number of proprietary factors, but takes into account the corporation's past history of creditworthiness. The rating is directly related to the price of the bond and the yield that is earned on it. Bonds that are rated AAA through BBB are known as investment grade. AAA and AA rated bonds represent the highest credit quality and lowest risk of default. A and BBB rated bonds are also investment grade, but of medium credit quality. They present a higher risk of default than AAA and AA rated bonds. BB, B, CCC, CC and C rated bonds are the lowest quality and are considered to be non-investment grade. Corporate bonds with these ratings are known as junk bonds. A bond rating of D means that it is already in default.
Corporate Bond Risks
This may seem obvious, but always make sure you understand what business the corporation is in and review its financials carefully before committing to a bond purchase, especially a long-term issue. A corporation with a credit rating that has been recently downgraded, combined with being in a business that is decline, will more than likely pay a higher return, but the risk of default will be much greater. While you may not lose the entire amount of the principal in the event the corporation defaults, you may only see pennies on the dollar returned.
Some corporate bonds have a call feature that presents a different type of risk. A bond that is callable can be "called away" from the bondholder at a point that is outlined in the terms and conditions. Corporations can call bonds for any number of reasons, but the primary reason is a drop in interest rates. If interest rates fall, the corporation can call the bond by returning the bondholder's principal and then reissue new bonds at a lower rate. This has the potential of creating two problems for the investor. First, he or she loses the income from the bond. Second, the return of principal could trigger a taxable event.
To counter call risk, investors will sometimes purchase bonds with a "put" feature. A put is the opposite of a call. With a put bond, the bondholder has the option of returning the bond to the issuer. In other words, he or she can put the bond back. Bonds with a put feature almost always pay a lower yield than bonds with a call feature because the risk resides with the corporation.
Tax Considerations of Corporate BondsInterest payments on corporate bonds are taxable at both the federal and state level. If a bond is sold for a gain within 12 months of purchase, the proceeds are taxed at ordinary income rates. If it is sold after 12 months, it is subject to capital gains tax. If the bond is sold for a loss, the loss can be used to offset a capital gain on another investment.
Zero-coupon corporate bonds are subject to complicated tax laws and all investors are advised to speak with a qualified advisor prior to buying and selling any bond that is issued at a discount to it's face value.
Choosing between an Individual Bond and a Bond Fund
There are many good reasons to choose a corporate bond fund over individual bonds. First, a bond fund offers instant diversification. Risk is spread across hundreds, if not thousands, of different corporate issues. Second, for investors who don't really understand how bonds work or what to look for when purchasing them, bond funds offer professional expertise and management. Third, dividends and earnings can be automatically reinvested and used to purchase additional shares of the fund. This is a great feature for those who believe dollar cost averaging is the best way to purchase mutual funds. And finally, bond funds usually have a very low initial minimum investment requirement. This means that almost all investors can afford to buy bond mutual fund shares and take part in the earnings.
In summary, corporate bonds provide a way for investors to increase returns over government issued bonds, but with additional risk. If you're thinking of investing in a corporate bond or a corporate bond fund, make sure it fits both your asset allocation configuration and your level of risk tolerance.
While we've covered the basics of bond investing here, there is much more to maximizing the success of your bond investing strategy. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
More Bond Guidance
- Bond Investment Guide — The complete guide to bond investing.
- US Treasuries — Details about how to invest in US treasuires.
- Municipal Bonds — Details about how to invest in municipal bonds.
- Bond Rates — Factors affecting bond rates, and how to find the best ones.
- Bond FAQ — Frequently asked questions about bond investing.