A corporate bond is a security issued by large, publicly traded companies. When you buy a bond, you're lending money to the company (issuer). The issuer uses bond money to fund costly business initiatives like construction, research, and manufacturing. Bonds are sometimes called fixed-income or debt securities, and are bought and sold through a brokerage service, on a commission basis.
When investing in bonds, the goal is to receive competitive interest payments (coupons) as scheduled and to receive full repayment of your loan at maturity.
Diversify your investments
If you're shopping for bonds to round out your asset allocation, corporates involve more risk than municipal (munis) or treasury bonds. Earning at a higher interest rate, corporate bonds might make sense for part of your allocation, provided you can tolerate the increased risk. Event risk refers to the possibility that the issuer could become another company's take-over target. If a takeover occurs, the terms of the target's bond debt may change significantly, disadvantaging you and other investors.
Corporate bond risks
Credit ratings help investors quantify some of the risks involved with a particular bond. However, evaluating credit risk is more complex for corporates than for munis. Besides analyzing the specific type of bond involved and the issuer's credit-worthiness, there are several other factors to consider: the trends within the issuer's sector; whether the corporation is best of breed for its particular sector; the quality of the management team; and the overall economic environment. If you feel uncertain about the issuer's core business or the wider business or economic environment, don't take the credit rating for granted. Do your own research.
An issuer who defaults is the worst-cast scenario for a bond holder. Default can impact your bond investments in two different ways. First, the coupon payments would either be temporarily suspended or cease entirely. The second, and far worse, is if an issuer cannot return face value at maturity to bond holders as promised. Even if you are able to collect payment, you'll likely receive only pennies on the dollar and not the full value of your investment.
Although not guaranteed, corporate bonds rated investment-grade or higher have a low chance of default. The rate of default is much higher for high-yield bonds, fittingly referred to as junk bonds. These investments should be avoided by all but the most advanced, well-capitalized, and savvy fixed-income investors, who can handle the risk.
In addition to the risk factors, investing in corporate bonds involves complex provisions. Corporate bonds may feature equity components, floating coupons, or other unique features. Review the fine print carefully and be sure you understand fixed-income securities before investing.
Corporate bonds are also fully taxable at the federal, state and local levels — which is not the case with tax-exempt munis or treasuries.
Investment time horizon
Depending on your objectives, asset allocation, risk tolerance, and available capital, your investment time horizon may vary. Try to choose a bond with a maturity date that coincides with your financial plans. Some investors gradually shift from higher-risk investments like stocks to high-quality, investment-grade corporate bonds as the time horizon for a given financial goal approaches. When comparing bond investments, be sure to keep your time horizon, after-tax yield, and risk tolerance in mind.