A corporate bond provides companies with cash and investors with income — here's how to evaluate the risks and rewards

Simon Chandler

Oct 31, 2020, 01:30 IST

A corporate bond provides companies with cash and investors with income — here's how to evaluate the risks and rewards

Corporate bonds generally pay a better interest rate than government bonds.Tapanakorn Katvong / EyeEm/Getty Images

A corporate bond is issued by a company to raise money; like any debt, it pays investors regular interest and a return of their principal when it matures.
Corporate bonds are ranked for quality and risk by credit rating agencies, based on the financial soundness of their issuing company.
Higher-rated, "investment grade" corporate bonds consistently pay a higher interest rate than US Treasuries, at relatively little risk.

Just like people, businesses often need to borrow money — to finance new ventures, pay off old debts, or even to buy another firm. One method at their disposal is to issue bonds.

A corporate bond, like any bond, is basically a type of debt. The purchaser of a corporate bond effectively lends cash to the issuing company. In exchange, the company becomes obligated to pay interest on this principal sum and to return it in full after a set period, when the bond matures.

For investors, corporate bonds offer a source of income — one that's more reliable than stock dividends, since the interest payments are usually fixed, and more lucrative than ultra-safe-but stolid US Treasury bonds. Of course, in the investment world, there's always a tradeoff between risk and reward. And the reliability of corporate bonds can vary, depending on the company issuing them.

What is a corporate bond?

The main purpose of corporate bonds is to help companies raise additional cash, without having to borrow from a bank, sell equity — that is, issue more stock shares — or seek out venture capitalists.

"Companies issue bonds to raise cash to bolster their balance sheets or re-invest in a particular project or expansion plan, " says Susannah Streeter, a senior investment and markets analyst at Hargreaves Lansdow. "Investors who buy corporate bonds are lending money to the company, in the same way as investors who buy government bonds like US Treasuries or UK Gilts are lending money to governments to finance public spending."

Bondholders are entitled to two sources of income:

The regular interest installments, usually paid annually or semi-annually. Most bonds pay a fixed interest rate, but variable-rate, or floating, bonds exist too. These are usually based on a benchmark, such as a bond index or prevailing Treasury rate.
A full repayment of the principal after the bond's term ends. Corporate bonds generally have maturities from three years to 10, though they can be shorter or longer.

After they're issued, corporate bonds trade on stock exchanges, in the secondary bond markets. Investors can always choose to sell a bond at market price before it matures. This move may be profitable if interest rates, in general, have declined since the bond was issued: A fall in interest rates sparks a rise in bond prices — because that bond is paying a now higher-that-average rate.

How are corporate bonds evaluated?

In terms of risk, corporate bonds are not all created equal. Much depends on the company issuing them — specifically, on its creditworthiness (the soundness of its finances and ability to pay its debts). This is expressed by its credit rating, something akin to an individual's credit score.

Corporate credit ratings are provided by the three major credit rating agencies: Moody's, Fitch, and S&P. The rating systems used by these independent firms differ from each other slightly, but they all use letter grades:

A ratings are assigned to companies deemed to be subject to the lowest level of credit risk
B ratings usually indicate some moderate credit risk
C ratings indicate very high credit risk
D ratings are reserved for companies in default, or bankrupt

Any bond rated BBB (for Fitch and S&P) or Baa (for Moody's) or above is considered "investment-grade," which — as the name implies — indicates the most suitable choice for investors.

In contrast, any corporate bond with a rating below BBB (for Fitch and S&P) or Baa (for Moody's) is classified as "non-investment grade." This doesn't mean they're off-limits to investors, just that they're higher-risk — and so they pay higher interest. Officially, they're called "high-yield bonds" — or, more colloquially, junk bonds.

Why invest in a corporate bond?

Corporate bonds have a variety of advantages, including:

They're a good source of income

"Corporate bonds traditionally offer very attractive yields because they carry more credit risk than government bonds," says Edward Moya, a market analyst with New-York based forex broker OANDA.

But then, just about everything does, since government bonds are considered virtually risk-free. "Corporate bonds which have attracted a high-quality rating are viewed as a relatively safe investment," says Susannah Streeter.

While average yields will vary according to the economic cycle, investment-grade corporate bonds usually offer rates that are two to three percentage points higher than US Treasury bonds. For example, Intel and Coca-Cola — two companies with an A1 rating — are paying a 4% and 3.25% rate on bonds that mature in 2022 and 2024, respectively.

The difference tends to grow during downturns and shrink during expansions when Treasuries have to offer higher rates to attract buyers.

They diversify your portfolio

Corporate bonds can help investors diversify their holdings. Debt instruments like bonds often act as a counterbalance to equities, moving opposite to stocks.

"Many investors want to build a balanced portfolio. Including bonds can offset the higher risk of buying shares in companies with ambitious growth strategies," Streeter says.

They can offer capital gains

While corporate bonds are basically an income investment, it's still possible for investors to speculate with them. Given that bond prices can fluctuate depending on the interest rates and economic conditions, corporate bonds can present opportunities for profit during volatile periods.

This is particularly true of junk bonds, which have historically behaved more like equities than low-risk corporate bonds. The correlation between junk bonds and equities even increased since the onset of the coronavirus pandemic, buoyed by the Federal Reserve's commitment to buy corporate bonds.

Of course, you have to time the selling of your bonds carefully and be ready to move fast when prices rise.

Risks associated with corporate bonds

Where there's reward, there's also risk, and corporate bonds are no exception.

Credit risk: The company could default

Credit or default risk relates to the possibility that a company may get into financial straits, impairing its ability to make its interest payments — and even the principal on its bond. "Should a company go bust, bond investors may lose money," says Streeter. "However, even bankrupt firms must pay creditors, including bondholders first, before reimbursing investors who hold the company's shares," she adds.

Call risk: You could lose the bond

Some corporate bonds include a call provision, which provides the company with the ability to repurchase, or "call," the bonds at face value before maturity. This is particularly risky for investors in situations where interest rates have fallen and market prices for bonds have risen since it would deprive them of the ability to make a profit from selling their bonds on the open market. And of course, you lose the interest from the bond, and may not be able to find another with an equally good rate.

Liquidity risk: You could find it hard to sell

The bond market has historically lacked the pricing transparency of the stock market. This is more of a problem for bonds issued by private companies or smaller firms that trade over the counter. Investment-grade bonds issued by bigger companies are less likely to run into this issue.

Interest/inflation risk: The bond loses value

This is a systematic risk that's faced by every fixed-interest bond: Potential interest rate rises will cause the market value of bonds to fall. There's also the problem of inflation, which could erode the value of interest payments and the face value of a bond reaching maturity.

Generally, the longer the bond's maturity, the greater its vulnerability to these risks; that's why longer-term bonds pay a bigger interest rate.

How to buy corporate bonds

There are two ways to buy corporate bonds.

Individual bonds: Corporate bonds are issued and sold in blocks of $1,000. Individual investors can buy them through Investment platforms, brokers, and financial services companies such as Fidelity, Vanguard, and E*TRADE, which charge fees of anything from $1 to $2 per bond. Banks such as Wells Fargo and Morgan Stanley also let you buy individual bonds, although these generally charge higher fees.
Bond funds: "Most investors buy a corporate bond fund, as this spreads risk and allows lower investment entry amounts," says Susannah Streeter. Bond funds can be either mutual funds, like the Payden Corporate Bond Fund (PYACX), or exchange-traded funds (ETFs), like the iShares iBoxx $ Investment Grade Corp Bond ETF (LQD).

The financial takeaway

The main attraction of corporate bonds is that they offer a safe income stream, assuming that the companies issuing them have high credit ratings. Corporate bonds offer higher returns than you'll likely find with government bonds.

They can be also used by less risk-averse investors to speculate, with falls in interest rates tending to increase bond prices. Such strategies come with a number of dangers, chief amongst them being the risk that interest rate rises will depress bond prices.

There's also the omnipresent risk of default, which would deprive bondholders of interest payments and potentially their entire investment.

These caveats aside, corporate bonds (and bond funds) can serve as key elements in a diversified portfolio — provided you know which ones to pick.