Last Updated on 19 September, 2022 by Samuelsson
What are Corporate bonds?
Investors are always looking for ways to earn better returns and minimize risk, and corporate bonds seem to offer some comfort. So, you may want to know what corporate bonds are, their pros, and their cons.
Corporate bonds are a type of debt instrument issued by publicly traded companies and traded by investors on the secondary market. The cons of investing in corporate bonds include fixed income, structured payment schedules, higher returns than government bonds, and the ability to convert to shares. Some of the cons are lack of capital growth, higher risks than government bonds, and lack of liquidity.
In this post, we will take a look at the following:
- What is a corporate bond?
- Understanding how corporate bonds work
- What are the three types of corporate bonds?
- What are corporate bonds examples?
- Are corporate bonds a good investment?
- Are corporate bonds high risk?
- What are the pros and cons of corporate bonds?
- Corporate bonds vs. government bonds
What is a corporate bond?
A corporate bond is a type of debt instrument issued by a publicly traded company and traded by investors on the secondary market. It has a fixed interest payment and a maturity period at which the company would return the original investment to the investors.
During the life of a corporate bond, the company makes regular interest payments to the investors for using their capital to run its business. When the bond expires, the company returns the original investment to the investors.
Given that investors’ capital is usually returned at maturity — baring any huge financial mishap that could cause a default — a bond is considered safer than stocks where the capital can potentially decline to zero. However, the backing for the bond is generally the company’s ability to repay, which is why bonds of highly profitable blue-chip companies have high ratings while bonds of unstable companies are considered junk bonds.
Understanding how corporate bonds work
As you may already know, companies raise funds for their various projects via equities or debts. Since issuing too many equities dilute the value of their shares, they often use debts to finance their projects. Bond issuance is one of the ways companies use debts to raise capital for their projects.
Rather than borrow from financial institutions, companies issue bonds to borrow money directly from the investing public by issuing bonds, which come with lower interest rates than bank loans. Also, issuing bonds affords companies more freedom to operate as they see fit, as they would not be under the restrictions that are usually attached to bank loans.
On the aspect of investors, bonds offer a great way to earn some interest while ensuring that their capital is not lost to market volatility as it’s the case with investing in stocks. At maturity, the original investment is returned to bond investors. Meanwhile, all through the life of the bond, they earn regular interest payments. Bond holders’ interest payment is considered first before preferred and common equity dividends in every accounting period, and in the event of bankruptcy, bondholders are the priority.
However, that investors’ capital is preserved does not make corporate bonds a risk-free investment. There are still some risks because, generally, the backing for any corporate bond is the ability of the company to repay, which depends on its prospects for future revenues and profitability. Although the company’s physical assets may be used as collateral in some cases, there is no assurance that it can always cover investors’ funds.
Generally, corporate bonds are considered to have a higher risk than U.S. government bonds, which is why interest rates are almost always higher on corporate bonds — even for companies with top-flight credit quality. The difference between the yields on highly-rated corporate bonds and U.S. Treasuries is referred to as the credit spread. High-quality corporate bonds are considered a relatively safe and conservative investment. But that is only for well-run companies. Bonds of unstable companies are considered junk.
What are the three types of corporate bonds?
There are many ways to classify corporate bonds, such as the maturity period, whether or not it is collateralized, and whether it is convertible to stocks. However, the more popular way to classify bonds is based on the maturity period, which is how long the company has before it is expected to pay back the principal to investors.
Based on maturity, bonds can be classified into short-term bonds, medium-term bonds, and long-term bonds. Short-term bonds have less than three years maturity, while medium-term bonds have four to 10 years maturity. For long-term bonds, the maturity period is more than 10 years, and such bonds usually offer higher interest rates — though they may come with additional risks.
What are corporate bonds examples?
Corporate bonds are seen all over the market and can be traded by investors. Let’s take a look at some examples to see how corporate bonds work.
Let’s say that Company XYZ issues a seven-year bond on February 1, 2018, for $1000 per unit at the rate of 5% and YTM of 6%.
In this case, the principal is $1000, and the maturity is February 1, 2025 (seven years from the issue date). The yield to maturity is 6%, while the coupon rate is 5%.
Assuming Company QY issues a five-year bond on May 1, 2019, which cost $100 each and pays 6%, with the first payment made six months after the issue date. The interest payment is half-yearly (six months), and the YTM is 6%. Every six months, the investors receive half of the annual 6% coupon rate. The maturity date is May 1, 2024, so on that date, the investors would get their principal back.
Let’s say that you purchase a bond with a 5% coupon rate from Company ABC, and the bond has a face value of $500. This means you will receive $25 in interest payments per year ($500 x 0.05). Some corporate bond issuers usually make payments in six-month installments, so you might receive $12.5 in January and the other $12.5 in June.
The information about the payment schedule is normally found in the prospectus, indenture agreement, and bond certificate for disclosures. Always make sure that you check all those.
Are corporate bonds a good investment?
Yes, corporate bonds are good for investment if you can find highly-rated ones with good yields. In fact, high-grade corporate bonds should constitute a reliable source of income for your portfolio, as they can help you accumulate money with minimal risks.
However, finding the right corporate bonds to buy is not easy. You have to do some research to get your corporate bonds list. Corporate bonds are issued by companies, which can be either public or private companies. Bonds offer them great flexibility in how much debt they can issue. Usually, the maturity can be anywhere from less than 5 years to more than 10 years.
Are corporate bonds high risk?
Some corporate bonds carry high risks. The major corporate bonds risk comes from the default when the company is not solvent enough to meet its interest obligations or pay up the principal. This is expressed as the default rate. The default rate is the likelihood an issuer does not pay the coupon rate or principal.
The first way to calculate the default rate is to divide the number of issuers that defaulted by the total number of issuers at the beginning of the year. Another way is to take the dollar amount of defaulted bonds and divide it by the total par value of all bonds outstanding.
Interestingly, during the 25 years between 1970 to 1994, 640 out of 4,800 corporate issuers, only 0.13%, defaulted on a bond, and that includes corporations that missed payments or delayed payments. Given the way default payment is calculated, it is important to take into account recovery rates since investors sometimes recover payments that were delayed. The recovery rate for corporate bonds is around 38%.
While there are many good U.S. corporate bonds, a lot are junks. As a rule, corporate bonds that pay the highest yields offer the most risk. It is important to check their ratings. Corporate bonds are rated by services such as Standard & Poor’s, Moody’s, and Fitch, which calculate the risk inherent in each specific bond. The most reliable (least risky) bonds are rated triple-A (AAA). A junk bond comes with a credit rating of “BB” or lower.
What are the pros and cons of corporate bonds?
Corporate bonds have many advantages and disadvantages. Some of the pros of investing in corporate bonds are as follows:
- Higher returns than government bonds: Corporate bonds tend to offer higher returns than Treasury bonds. However, there is a little more risk associated with corporate bonds compared to government bonds or other types of bonds. Interestingly, you can also trade bonds from reputable companies even if interest rates fall.
- Fixed income and structured payment schedule: With corporate bonds, you know for certain about the interest payments you’ll be receiving when you invest in a corporate bond. Unlike dividends, which are at the discretion of the company, the coupon payments are structured, so you have more certainty about getting a return on their investment.
- Bondholders rank higher than shareholders: In the event of insolvency, bondholders are paid first from the company assets before shareholders. This higher priority gives you a better chance of recovering most, if not all, of your investment even if the company goes under.
- Stable pricing: The pricing is more stable than that of shares. There won’t be the same price fluctuations with corporate bonds as you will with shares or other investment opportunities. So, you can know with some certainty what the face value of the bond will be and have some predictability on what your income stream will be over the life of the investment.
- The ability to convert them to shares: Some bonds can be converted to shares of the company that issued them. This adds to the risk assumed by the investor, but it also means that the investment can be sold at the current market value. Investors can use this method to rake in more profits under the right circumstances.
Investing in corporate bonds also comes with some disadvantages. These are some of the cons of investing in corporate bonds:
Lack of capital growth: Generally, corporate bonds do not provide any significant capital growth, as the investment is not designed to increase in value over the life of the bond. While you will receive timely interest payments assuming the company does not default on them and receive your initial investment back in full plus the interest at the maturity date, there will be no significant increase in the capital even when you sell at the secondary market before maturity.
Does not diversify your portfolio: Buying the bonds and shares of the same company does not diversify your portfolio. If the company goes under for some reason, you could be left with some big losses and little chance at recovery.
Not always easy to sell: If you want to get out of a corporate bond before it matures, then selling it on a secondary market can be a little difficult. There’s a good chance that you won’t receive the complete face value of the bond, especially if interest rates have gone up since you made the investment.
Low liquidity in the secondary markets: There are times you won’t even be able to find buyers who are interested in a corporate bond as an investment on the secondary market. That can make it hard if you need to liquidate to raise some cash right now.
Reduced profitability when there is a rise in interest rates: A rise in interest rates can make investing in corporate bonds less profitable. In addition, the value will be affected by the stability of the company. Both the interest rate increase and reduced profitability on the part of the company can affect your bond investment on an individual level.
Corporate bonds vs. government bonds
While corporate bonds are issued by companies, government bonds are bonds issued by the federal, state, or municipal government or government agency. Corporate bonds are riskier than government bonds.