What Is a Corporate Bond and How Do They Work?

The stock market crash of the late 2000s taught many investors a painful lesson about the importance of diversifying their investments. They should stick to low to medium-risk investment vehicles that provide a trade-off between safety and investment returns.

Corporate bonds are one such vehicle. They can provide predictable interest payments at a manageable level of risk for income-seeking investors. They occupy a middle ground between low-interest, low-risk government bonds and stocks. These loans may offer higher returns but are generally riskier.

However, corporate bonds are not perfect. Some types of corporate bonds have significant disadvantages. Careful consideration should be given before investing.

What Is a Corporate Bond?

Both private and public companies sell corporate bonds to raise money for business operations. In return, they pay you interest on the amount you receive.

Like other interest-paying assets, companies use corporate bonds to finance high capital-required projects. The term simply covers any investment a company may make. For example:

• Construction of a new warehouse or production building
• Buying or leasing a new property
• Purchase or lease of new equipment
• Taking inventory

They usually come in denominations of $1. This amount, also known as “par value,” is the amount the company, known as the debt issuer, owes the debt holder at maturity. Some bonds require investors to buy more than one exchange. Therefore, they may have a minimum purchase amount. For example, $1,000 or $3,000.

Structure of Corporate Bonds

Corporate bonds make regular interest payments to their investors, popular with investors looking for income, from financial institutions looking to fill higher-risk investments to retired investors looking to earn interest income over a period of time.

Maturity & Call Date

Like US Treasury bonds, corporate bonds have a specific maturity date. At maturity, you receive back the original amount of your investment. The maturity period for corporate bonds, the period between their date of issue and their maturity date, ranges from one to 30 years.

Corporate bonds with a maturity of less than one year are known as “corporate paper” or “short-term financing.” The most common investors in these debts are likely to be larger financial entities, including banks, mutual funds, and hedge funds, rather than individual investors.

Many corporate bonds also have call dates. Call dates are the earliest dates on which the issuing company can legally buy back debt from investors if the money is no longer needed.

Prospectus

Before a company releases a new bond to the general public, it must issue a prospectus describing the intended use of the money. This requirement applies even to private companies that are not listed on any stock exchange.

The prospectus describes the term of the bond, including its final maturity date and call date. It also describes the initial interest rate of the debt and how and when issuers pay interest on the debt: quarterly, semiannually, annually, or in nominal amounts when redeeming the debt.

Finally, the prospectus states the right to repay the borrower if the lending company fails or declares bankruptcy. This includes how investors get paid based on their investor type and depends on whether the bond is secured or not.

Secured vs. Unsecured Corporate Bonds

Corporate bonds may or may not be secured.

Covered bonds are backed by certain types of collateral, such as commodities, real property, or cash. When a corporate debt issuer declares bankruptcy, secured debt holders have the right to seize the collateral.

Unsecured bonds, also known as debentures, are guaranteed only by the company promising to repay. Unsecured lienholders do not have the right to seize the property. In the event of bankruptcy, they may be obligated to pay future interest payments as well as a significant portion of their principal payments.

Some types of bonds are always unsecured, such as convertible notes (which can be converted into shares of the company). Others may be fixed-price and floating-rate bonds, for example. You can find the protected status of the bond in the prospectus.

Because unsecured bonds are considered riskier for investors, their interest rates are higher than those of secured bonds. However, convertible bonds tend to come with lower interest rates because they can be converted into common stock.

Corporate Bonds vs. Preferred Stocks

Corporate bonds share some features with preferred stock, such as regular payments to investors. These similarities are enough to cause confusion for inexperienced investors.

But there are some important differences between the two:

• Debt vs. Equity: A corporate bond is a debt instrument that does not provide any ownership interest in its issuer. In contrast, preferred stock represents an ownership stake in the parent company.
• Liquidity: You can trade both corporate bonds and preferred stocks in the secondary markets. However, preferred stocks often trade on stock exchanges, increasing the potential market size and making it easier for investors to buy and sell them.
• Priority of Payment: In bankruptcy, preferred stockholders are entitled to payment before common stockholders but after corporate debt holders.
• Conversion to Common Stock: Under certain circumstances, you can exchange convertible corporate bonds for common shares of the issuer. In contrast, it is difficult or impossible for debt holders to exchange their holdings for shares. You can always exchange preferred stock for common stock at an agreed-upon rate.

Types of Corporate Bonds

Corporate bonds come in several different forms, and a given bond may fall into more than one of these categories.

Fixed-Price Bonds

This type of bond carries a fixed interest rate throughout its life. This rate is determined by the credit rating of its issuer at the date of borrowing. Companies with higher credit ratings pay lower interest rates on their bonds, while those with lower credit ratings pay higher rates.

Fixed-interest bonds usually have semiannual interest payments and are currently the most common type of corporate bond.

Variable-Price Bonds

Interest rates on floating-rate bonds change in response to fluctuations in long-term interest rates. Most bonds reset once a year. Their interest rate is determined by the market interest rate at each reset date and the company’s credit rating.

Floating Exchange Rate Bonds

Interest rates on floating-rate bonds fluctuate with market interest rates, such as Libor or the Federal Reserve’s federal funds rate, and the company’s credit rating at each reset date. Unlike annual adjustments to floating-rate bonds, changes to floating rates typically occur after each quarterly interest payment.

Zero-Coupon Bonds

Zero-coupon bonds pay no interest. Instead, they trade at par (face value) at deep discounts. At maturity, an investor can redeem their zero-coupon bonds at par value, earning a return on their initial investment.

Callable Bonds

Issuers of callable bonds have the right to redeem them after the expiration of the initial lock-in period but before maturity. The first date on which issuers can redeem the bonds is known as the call date.

Redemption is always voluntary. For example, a company issuing a callable bond with a final maturity date of January 31, 2030, and a call date of January 31, 2024, may, but is not required to, redeem the bond after the earlier of the two dates.

If called, the debt is usually redeemed at par value plus unpaid interest. Callable bonds can have a fixed, variable, or floating interest rate.

A company may call a bond for a variety of reasons, but in most cases, it’s because prevailing interest rates have fallen, and the existing debt allows for lower interest rates on new debt issues.

Typically, callable debt is replaced with lower-yielding debt. Therefore, investors in callable bonds may have to accept a lower yield on future debt purchases with a similar level of risk. They also forego future interest payments on the callable debt. Both factors reduce their total return.

Putable Bonds

These types of bonds, also called “1000” and “10-100,” give bondholders the right to request repayment of principal and all accrued interest from the issuer after a specified date.

This often occurs when the owner of the bond dies. Deceased bondholders may have a “survivor’s option” with the right to sell their bonds back to the issuer.

Bondholders can also exercise this option in inflationary conditions. As prevailing interest rates rise, bonds with low-interest rates become less attractive, and their market value declines. It makes sense for bondholders to exercise this put sooner rather than later and invest in bonds that offer higher yields.

Because they offer the potential for early repayment to bondholders, putable bonds are less risky and more attractive investments. This is why their interest rates are typically lower.

Convertible Bonds

Convertible bonds allow bondholders to convert them into a certain number of the issuer’s common stock. This allows the bondholder to obtain an equity interest in the company.

Like callable and putable bonds, convertible bonds come with restrictions on how and when conversion to stock can occur. They are also more sensitive to fluctuations in the issuer’s stock price than other types of bonds.

Corporate Bond Ratings

Every corporate bond is rated by at least one of the major US rating agencies – Fitch, Standard & Poor’s, or Moody’s. Each entity has its own letter-grade scale, but the most important distinction is between two broad categories of risk: investment grade and non-investment grade.

Non-investment-grade bonds have become as popular as “junk bonds.” In more polite circles, they are known as “high-yield bonds.” All bonds rated below BBB on the S&P scale, the most commonly used measurement unit in the US, are considered non-investment grade.

A bond’s yield is inversely proportional to the issuer’s credit rating. The higher the rating, the lower the yield.

Low-grade bonds come with a higher risk of default. But they also offer high interest rates — much higher than what investors earn in a savings account or CD. It’s worth the risk for some people.

Corporate debt holders are more likely to prioritize security over equity holders. While a publicly traded company can suspend dividends on common or preferred stock at any time, every company that issues corporate debt has a legal obligation to make regular interest payments. The only way out is to liquidate their bonds or declare bankruptcy.

How to Buy and Sell Corporate Bonds?

Like mutual fund initial public offerings, institutional investors, brokers, fund managers, and individual professional investors tend to handle new debt issues. While it is possible for rank-and-file investors to purchase new corporate bonds on the primary market, this may require swift action due to the relatively short offering provisions of issuers.

Fortunately, corporate bonds are fairly easy to buy in the secondary market. All you need is a brokerage account that enables this.

If so, then you should search its database and explore the thousands of coupons that are publicly available — from investment-grade bonds issued by blue-chip companies to those from less-established companies.

If you want to own debt from a specific issuer, you can look for individual bonds. If you’re looking for bonds that match more general yield, credit rating, or maturity criteria, customize your search to find them.

Buying Bonds in the Secondary Market

Most brokers offer sophisticated search tools that allow you to search for bonds by industry, minimum purchase amount, yield, issuer rating, and maturity date. While no broker offers access to every corporate bond on the market, you’re likely to find one that fits your needs.

Many online brokers’ help sections offer guidance on the buying and selling process, but it’s no more difficult than buying regular stocks.

In the secondary market, most corporate bonds are traded over the counter as OTC stocks. “Over the counter” just means you don’t get them on the official exchange.

Depending on prevailing interest rates, bonds sold in the secondary market may cost more or less than $1 on the exchange. Bonds in both the primary and secondary markets can have minimum purchase amounts of $5,000 — five units or more.

Not all corporate bonds can be purchased through a broker. Some of them are only available through mutual funds and exchange-traded funds. These funds consist of market-traded assets, including stocks, debt, commodities, or a mix.

You can choose from a variety of funds that focus on corporate bonds or include them as part of their asset portfolios. Many private bonds underlie typical debt funds.

Because buying individual debt takes time and requires a significant amount of capital, it often makes more sense for individual investors to buy debt funds. But before you invest, read each fund’s prospectus to determine what is currently in it and what may be added to it in the future.

Pros and Cons of Corporate Bonds

Corporate bonds appeal to many different types of investors, but they also have drawbacks. Before you invest, familiarize yourself with what they entail.

Pros of Corporate Bonds:

• Corporate bonds offer relatively high and predictable returns across a wide risk-reward spectrum. They are likely to be at least partially repaid in bankruptcy as well.
• They provide higher yields than state-supported bonds of the same tenure, including inflation-protected bonds such as Series I savings bonds.
• They offer relatively stable returns compared to dividend-paying stocks, even low-volatility, high-yield blue chips, and value stocks.
• You can buy corporate bonds in smaller denominations, making them accessible to a wider range of investors.
• In bankruptcy, bondholders have priority over stockholders, increasing the likelihood of repayment.
• Corporate bonds come in various risk levels, allowing investors to choose according to their risk tolerance.

Cons of Corporate Bonds:

• Not all corporate bonds are available through brokers, reducing liquidity and increasing price spreads.
• Some bonds may be hard to find for regular investors, making debt funds a more practical option.
• Access to the primary market for regular investors is limited, as it is dominated by professionals.
• Call risk can result in lower-than-expected returns if the issuer calls the bond.
• Interest rate risk affects both floating and fixed-rate bonds, potentially reducing returns.
• Fixed-rate bonds may not provide protection against inflation, unlike inflation-protected bonds and other assets.
• In rare cases, corporate bondholders can suffer significant losses due to insolvency or default, making government-backed bonds a safer option for risk-averse investors.

Corporate Bonds FAQs

Get all the answers to your questions about corporate bonds before you invest.

What Happens If the Company Goes Bankrupt?

In short, debt holders may receive less, and sometimes significantly less, than what they paid for the debt. In Bond-speak, this is known as a “haircut,” and it’s an expected outcome when a bond issuer declares bankruptcy.

Secured debt holders have more protection than unsecured debt holders. In some cases, unsecured loan holders can recover their entire investment, despite losing most of their initial capital.

What Is the Difference Between Corporate Bonds and Stocks?

Corporate bonds are not as liquid as stocks. While you can buy and sell them on the secondary market, it’s not as straightforward as trading shares in major companies like Walmart, Apple, or Ford.

On the other hand, most corporate bonds provide regular interest payments or guarantee a return to the owner. Stocks, especially those that don’t pay dividends, do not offer such guarantees. Even dividend stocks can cease dividend payments if the company’s financial health deteriorates.

What Happens to Corporate Bonds When Interest Rates Rise?

The prices of existing bonds typically decline when prevailing interest rates rise. Borrowers understand that they can secure higher interest rates on new loans issued under these elevated interest rate conditions.

What Is a High-Yield Corporate Bond?

A high-yield corporate bond is a polite term for a “junk bond.” According to rating agencies, these bonds carry a relatively high probability of default. While they offer attractive returns, high-yield corporate bonds are considered risky investments.

Bonds rated below BBB on the S&P scale are classified as junk bonds. Bond funds generally avoid them, and regular investors should exercise caution.

What Happens When the Corporate Bond Mature?

The maturity date of corporate bonds is when the issuer must repay the face value of the bond, along with any unpaid interest. If you hold a bond until maturity, you will receive a cash payment that you can either spend or reinvest as you see fit. Neither you nor the issuer have any further obligations to each other.

Conclusion

Corporate bonds offer pre-defined returns, manageable risk, and the backing of reputable corporations. Furthermore, some of the significant shortcomings of the corporate debt market have been significantly reduced in recent years. These improvements include improved access to new issues and increased liquidity for some bonds in the secondary market.

That said, corporate bonds may not be suitable for investors with very low or very high risk appetites, or those who wish to trade frequently. If you fall into either of these categories, you may find preferred stocks to be a better fit.