Picture this: You’re out to lunch with a friend and the sandwich you chose costs slightly more than the cash you have in your pocket. She spots you, and you promise to pay her back. The next morning, you buy her a fancy soy milk chai latte before work — it costs more than what you owed, but she had your back when it counted.
That’s similar to how corporate bonds work. When you buy a corporate bond, you spot a business some money now, and after some time they promise to pay you back in full, plus interest.
Bonds are typically thought of as a less risky investment type than stocks. But depending on the type of bond, like treasury or corporate, and who is issuing the bond, it can have varying levels of risk — and potential returns. That’s why it’s important to understand the ins and outs of whichever type of bond you invest in.
If you’ve been thinking about adding bonds to your investment strategy, take a moment to learn more about buying corporate bonds, how they can amp up returns in your portfolio, and what you should look out for along the way.
What are corporate bonds?
As you might have guessed from the name, corporate bonds are simply bonds issued by a company and bought by investors, like yourself.
Sometimes called debt securities, bonds help corporations borrow large amounts of money from investors that they may not be able to get from a bank, and often at a lower interest rate. They’re typically used to help a company:
- Fund a major project
- Purchase facilities or equipment
- Aid in other expensive undertakings
How do corporate bonds work?
Like other types of bonds, corporate bonds have loan terms that spell out the interest rate (often known as its coupon rate) and maturity date, which is when the face value of the bond is to be repaid back to you. Prior to the maturity date, you’ll receive interest payments (coupons) typically every six months.
At a bond’s maturity date, the corporation will pay you back the bond’s face value. Take note: The amount you receive may be different than what you paid for the bond. For example, if a bond’s face value is $5,000, it’s possible you may have purchased it at a premium (higher than face value) or discount (lower than face value) due to market circumstances.
Keep in mind, you don’t have to hold a bond until its maturity date. And certain corporate bonds, known as callable bonds, can potentially be bought (aka called) back by the company before their maturity date. This might happen if federal interest rates decline or if the bond issuer’s credit rating goes up, and the corporation can re-issue bonds at a lower rate.
Pro tip: Not all corporate bonds are callable, so it’s a good idea to check if a bond is callable or not before purchasing.
Certain corporate bonds called zero-coupon bonds don’t offer regular coupon payments. Instead, these long-term bonds pay out only at their maturity date. These are often cheaper than typical corporate bonds, but may be riskier investments as they can be affected by market volatility.
As you receive coupon payments for your bond, remember that corporate bonds (unlike municipal bonds) are taxable. If you buy them in a retirement account, they may offer a relatively high rate of return on a tax-deferred basis.
Corporate Bond Risks and Rewards
Just as different stocks have different levels of risk, so do bonds. And investing in corporate bonds is typically more risky than investing in other types of bonds.
For instance, government or treasury bonds are considered a pretty safe investment, as they’re backed by the “full faith and credit” of the U.S. government. Corporate bonds don’t have this level of backing behind them, but you can assess their potential risk. That’s because independent credit rating agencies, like Standard and Poor’s or Fitch Ratings, generate ratings for corporate bonds to help you know how much risk you may be taking on.
Quality bonds from highly stable companies are known as investment-grade bonds. This means there’s very little risk that the corporation will default or fail to make coupon payments.
Bonds that aren’t investment-grade — but are also not in default — are known as high-yield corporate bonds (and sometimes referred to as junk bonds). These types of bonds have a much higher rate of default, but usually also provide a higher potential return due to higher interest rates.
The coupon rate of a bond is based mainly on credit quality and its time to maturity. So a bond issued by a company with a lower credit rating — and a higher risk of defaulting — will have a higher interest rate. Likewise, bonds with longer times to maturity have higher interest rates, as they’re more likely to be affected by changing federal interest rates and inflation.
Why invest in corporate bonds?
When building your investment portfolio, you should aim to include a mix of securities and assets help increase diversification and lessen your overall risk. Allocating a portion of your portfolio to bonds can help you do this.
Pro tip: Want to earn a higher rate of return on bond investments? Consider choosing corporate bonds over municipal or treasury ones. Just remember, unlike other types of bonds, these fixed-income securities are not always low-risk investments.
Buying Corporate Bonds
You can buy corporate bonds on two different markets. The primary market is where newly issued bonds are purchased and, like a stock, these transactions happen through a bank, broker, or bond trader. Bond prices on the primary market are similar to stock initial public offerings, and everyone who buys a newly issue bond pays the same offering price.
Some corporate bonds are sold on the secondary, or over-the-counter, market. These are typically bought and sold through a broker and may offer more liquidity than bonds on the primary market.
When buying corporate bonds, you can purchase individual bonds — or you can invest in bond ETFs or mutual funds. The benefit of investing in a bond ETF is your portfolio will automatically be exposed to a diversified mix of these fixed-income securities.
If you are aiming to add diversification to your portfolio, invest in fixed-income securities, and score potentially higher returns than treasury or municipal bonds, you may consider buying corporate bonds. You’ll be lending more than just sandwich or latte money to a corporation, but your return will possibly be greater, too. And that’s a tasty prospect.