Corporate bonds

What are corporate bonds and how do they work?

Corporate bonds are excellent investments for those seeking higher yields and can withstand increased risk

What is a corporate bond?

In a nutshell, a corporate bond is like a loan from an investor to a company, which the company repays with interest on the bond’s maturity date.

Companies see bonds as an attractive way to raise funds for their operations or capital expenditures because the interest they have to pay to investors is less than what they would have to pay to a bank through a loan . And unlike the sale of stocks, a company does not give up its ownership rights when it issues bonds.

There are many types of corporate bonds, although most are issued with maturities between 1 and 30 years. Bondholders generally receive regular interest payments, known as coupon, which is determined when the bond is issued. Corporate bonds are subject to state and federal taxes in addition to capital gains taxes.

How are corporate bonds different from treasury bills?

Corporate bonds are issued by corporations, while treasury bills are issued by the federal government. Treasury bills are considered the highest quality securities available because they are backed by the “full confidence and credit” of the US government and, therefore, are virtually default proof. They are also exempt from state and federal taxes.

In addition, treasury bills are considered benchmarks for other types of bonds; for example, the 10-year Treasury is used as the benchmark for the performance of all 10-year bonds.

How are corporate bonds different from municipal bonds?

State and local governments issue municipal bonds to finance public projects, while corporations issue bonds to raise funds. Municipal bonds often benefit from tax exemptions, unlike corporate bonds.

How are corporate bonds classified?

Corporate bonds are classified by maturity. They are generally grouped into three categories:

  1. Short term, which have maturities of less than three years;
  2. Middle term, which are maturities between 4 and 10 years; and
  3. Long term, which mature in more than 10 years. Long-term bonds generally have higher coupons than short-term bonds, but they also come with increased risk.

How are corporate bonds rated?

Rating agencies such as Moody’s, Standard & Poor’s and Fitch Ratings rate bonds based on their creditworthiness, that is, their ability to make payments on time. They assign ratings to corporate bonds, which range from AAA (highest) to D (lowest).

Obligations rated B and above are considered investment grade. Bonds rated below BB are called junk bonds. This chart illustrates different bond ratings.

Standard & Poor’s

Bond rating Investment grade

AAA

extremely strong

AA

Very strong

A

strong

BBB

Adequate

BB

Faced with major uncertainties, although less vulnerable in the short term

B

Faces major uncertainties and is more vulnerable in the short term to adverse business

CCC

Vulnerable

CC

Very vulnerable to non-payment

VS

The fault has not yet occurred, although it is expected

D

Default or bankruptcy

To compensate investors for the increased risk, lower-grade bonds typically offer higher coupons than investment-grade bonds. These bonds are also called high yield bonds. Remember that the higher the yield, the higher the risk of default, and in the event a company declares bankruptcy, its investors may not get all their money back.

TheStreet Dictionary Terms

Are corporate bonds guaranteed?

Corporate bonds are considered higher risk than government bonds because corporate bonds are only guaranteed by the companies that issue them. This means that if a company declares bankruptcy and defaults on its bonds, bondholders will have some claim on the assets of the company.

The order in which investors receive these assets is structured as follows:

  • If an investor bought a secured surety, the company had used its assets, such as property, plant and equipment, as collateral. These bondholders are legally entitled to these assets.
  • Not guaranteed bonds, on the other hand, are unsecured, although investors in this type of bond are entitled to the general cash flows of the company. Debentures are also known as debentures and are prioritized from senior to junior, and investors receive collateral in that order.

Which corporate bonds are rated AAA?

Currently, there are only two companies in the United States that have AAA-rated bonds: Johnson & Johnson and Microsoft. Investors can check SEC Filings to stay up to date with the latest reviews.

Types of corporate bonds

There are several types of corporate bonds, giving investors many options when it comes to a bond’s structure, yield, and credit quality. Here are the most common:

  • Fixed rate coupon bonds pay coupons on a fixed or regular basis, usually twice a year. The payment amount is a percentage of the face value of the bond.
  • Zero Coupon Bonds do not offer coupons. These bonds are issued at a discount to their face value, so the holder receives a profit at maturity.
  • Asset-backed bonds, such as asset-backed bonds (CDOs), allow investors to claim a company’s underlying assets in the event of a company’s default.
  • Convertible links can actually be exchanged for shares of the company, although this also makes them vulnerable to market volatility.
  • Callable and puttable bonds can be “redeemed” by the issuer before their maturity, and repaid either at their nominal value or at a percentage of this value. With puttable bonds, the investor can “return” the bonds to the issuer and receive the face value.

Risks Associated with Corporate Bonds

Compared to other financial securities, many types of bonds can be considered a relatively stable investment, but that does not mean that they are not subject to risks, such as:

  1. Interest rate risk: Bonds have an inverse relationship with interest rates. When rates rise, bond prices fall, which is why longer-term bonds carry higher coupons as compensation.
  2. Inflation risk: When prices increase, purchasing power decreases, which means that the value of a bond can deteriorate over time.
  3. Default risk: as indicated above, in the event of bankruptcy of a company, bondholders may or may not be compensated depending on their priority and whether their bonds are guaranteed.

Frequently Asked Questions (FAQ)

Still wondering about corporate bonds? We’ve compiled answers to some of the most common questions investors have about corporate bonds.

How are corporate bonds traded?

Corporate bonds are traded over-the-counter, usually with denominations of $1,000 or $5,000. Check with your bank or brokerage to find out what trading options you have.

In addition, FINRA, the financial industry regulator, introduced TRACE, which provides real-time prices for bonds and other securities, available on their site.

Can a corporate bond be sold before its maturity date?

Yes. Investors can sell corporate bonds before they mature, but in the case of long-term bonds, investors lose interest if they sell before five years. Also, changing interest rate conditions can make a bond less favorable than it was when it was originally purchased. Bond resellers must also pay brokerage fees, and the proceeds of any sale may be subject to state and local taxes.

When do corporate bonds pay interest?

Coupons vary, but typically corporate bonds pay interest in two installments per year, or semi-annually.

Does the Fed buy corporate bonds?

Believe it or not, the Federal Reserve has been one of the biggest buyers of corporate bonds. As part of its emergency stimulus after the COVID-19 pandemic shut down global financial markets, in March 2020 the Fed announced it would buy corporate bonds using its emergency powers . In July 2021, they owned almost $13 billion, presented in the form of ETFs. However, as part of the end of its pandemic stimulus, the Fed has pledged to sell these assets between June and December 2021.