Corporate bonds

What are corporate bonds? What do you want to know

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Corporate bonds are a way for a company to raise funds without issuing stock or equity and without borrowing from a bank. Corporate bonds can be a big part of your portfolio, but it’s important to understand how they work. Here’s what you need to know.

What is a corporate bond?

A corporate bond is a debt security, which means that the buyer provides money to the company in exchange for their promise to repay it later, with interest. Bonds typically pay interest twice a year, and then the principal is due when the bond matures.

Three terms to know about bonds

A corporate bond has three important components: face or nominal value; the interest rate; and the due date. Here’s why each of these things is important.

The face value, or face value, of the bond is the price the company wants to get for the bond. Most corporate bonds have a face value of $1,000. If you wanted to invest $100,000 in corporate bonds, you would buy 100 bonds at par. Bonds may or may not sell at par – this is where the law of supply and demand comes in.

The interest rate, sometimes called the coupon rate, tells you how much interest you will earn on the bond. Interest on corporate bonds is usually paid twice a year, but the interest rate is expressed in annual terms. If you buy a bond with a face value of $1,000 and a coupon rate of 10%, you will earn $100 in interest each year, in two installments of $50 each.

The due date is the date on which the obligation is due. Twenty years is a common maturity for a corporate bond, although most bonds can be ‘called’, or redeemed, by the issuer before the maturity date. If your $1,000 bond at 10% interest matures in 20 years, you will earn $50 in interest every six months for 20 years, for a total of $2,000 in interest. After 20 years, you will also get back the $1,000 you paid for the bond.

Zero Coupon Bonds

Some bonds, called zero-coupon bonds, pay no interest during the term of the bond. They are purchased at prices below par, and then the face value is paid when the bond matures. The investor’s return is the difference between the purchase price paid for the bond and the face value.

For example, a five-year zero-coupon bond with a face value of $1,000 might sell for $750. When the bond matures in five years, the investor receives $1,000. The difference of $250 represents the investor’s return on investment.

Corporate bond prices

The face value of a corporate bond is not necessarily the sale price. Since the interest rate and maturity date are set by the company, the price will fluctuate based on supply and demand. A corporate bond issued by a large company with strong financials may sell above par, while a bond issued by a smaller or newer company, or a company in weaker financial condition, may sell at a discount.

Whatever price you pay, when your bond matures, you will get face value.

If you bought a 20-year bond with a face value of $1,000 and a coupon rate of 10% for $900, you would earn $100 more on top of the $2,000 interest and the $1,000 at the due date. If you bought a 20-year bond with a face value of $1,000 and a coupon rate of 10% for $1,100, you would still get the $2,000 in interest and the $1,000 at maturity , but your return would be less because you would have paid an extra $100 to start.

So why don’t you just buy corporate bonds at a discount? Bonds are generally less risky than stocks, but they still carry risk. If the company issuing the bond goes bankrupt, you may not be able to get back the money you paid for the bond. However, in the event of bankruptcy, bondholders are paid before shareholders.

In fact, bondholders are second in line to be paid, behind the secured creditor. A secured creditor’s loan is secured by collateral, which is something of value that the company puts up when taking out the loan. If the business defaults on the loan, the lender can sell the collateral to get their money back.

What is the difference between corporate bonds and stocks?

Corporate bonds and stocks are similar in some ways, but opposite in others. As such, having both in your portfolio can be a good diversification strategy.

Obligations

A bond is a loan you make to the company. The company pays you interest for the term of the bond, and when the term is over, it also pays you back the money you lent it. The amount of interest and the amount of payout are fixed — you know how much money you will receive and when.

The risk is that the business goes bankrupt and if it does, you might not get all your money back.

Shares

When you buy stock, you are buying stock, a part of the company. The value of shares depends on what someone else will pay you if you want to sell. Presumably, if the company is making money and its prospects are good, the value of your investment will increase. But it could also go down.

You have no way of knowing for sure whether the value will rise or fall in any given day, week, or year. And if the company goes bankrupt, you risk getting nothing.

Good to know

Although bonds are less risky than stocks, any investment involves some risk. Never invest more than you can afford to lose.

FAQs

  • Are corporate bonds a good investment?
    • Corporate bonds can be a good investment if you are looking for a fixed rate of return over a certain period of time. They are often preferred by retirees because they tend to be less risky than stocks, but they can also offer lower returns over time.
  • How does a corporate bond work?
    • A corporate bond is a loan from an investor to the company. An investor buys a bond, the company pays the interest to the investor over the life of the bond, and then at some point the company pays back the bond amount to the investor.
  • What are the five types of corporate bonds?
    • – There are investment grade bonds, which are considered relatively low risk.
    • – There are non-investment grade bonds, also called ‘junk bonds’, which present a higher risk of default.
    • – Fixed rate bonds pay a fixed rate of interest for the full term of the bond.
    • – Floating rate bonds have an interest rate that can vary during the term.
    • – Zero-coupon bonds do not pay periodic interest, but are sold at a discount to face value. When the bond matures, the face value is paid to the investor.
  • Are corporate bonds high risk?
    • Most corporate bonds are not high risk because they pay a predetermined amount of interest over a predetermined period of time. There is a risk that the company could go bankrupt, so look for quality bonds from companies that have been in business for a long time and have strong financial results.
    • They are often preferred by retirees because they tend to be less risky than stocks, but they can also offer lower returns over time.

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About the Author

Karen Doyle is a personal finance writer with over 20 years of experience writing about investing, money management, and financial planning. His work has appeared on numerous news and finance websites, including GOBankingRates, Yahoo! Finance, MSN, USA Today, CNBC, Equifax.com, and more.