Corporate bonds are debt securities issued by a corporation to raise money for expanding the business, settling bills, making capital improvements, pursuing acquisitions, and addressing various other business needs.
Bonds are sold to investors, enabling the company to acquire the capital it needs. In return, investors receive a pre-agreed number of interest payments at either a fixed or variable interest rate. Once the bond matures, payments cease, and the initial investment is returned. The ability of the company to repay the bond is generally grounded in its projected future revenues and profitability. In certain cases, physical assets may act as collateral.
Key Takeaways
- Corporate bonds represent debt issued by companies to raise capital.
- Investors buying corporate bonds essentially lend money to the company in exchange for interest payments; these bonds also have the potential to be actively traded in the secondary market.
- These bonds are generally deemed riskier than U.S. government bonds and hence, usually offer higher interest rates to balance the increased risk.
- Top-tier bonds, known as “Triple-A” bonds, are deemed safest yet offer lower yields, whereas the least credit-worthy bonds are termed “junk bonds.”
Understanding Corporate Bonds
In the investment hierarchy, high-quality corporate bonds are often regarded as relatively safe and conservative investments. Investors usually incorporate bonds into balanced portfolios to counterbalance riskier investments like growth stocks.
Over time, investors typically secure more bonds as a protective measure for their accumulated wealth, with retirees substantially investing in bonds to establish a dependable income stream.
Corporate bonds typically carry a higher risk than U.S. government bonds, leading to higher interest rates. The disparity in yields between high-rated corporate bonds and U.S. Treasuries is known as the credit spread.
Corporate Bond Ratings
Before being offered to investors, bonds are assessed for creditworthiness by prominent rating agencies like Standard & Poor’s Global Ratings, Moody’s Investor Services, and Fitch Ratings.
These agencies utilize distinct ranking systems, with the highest-rated bonds often referred to as “Triple-A” or “AAA” bonds. Conversely, the lowest-rated bonds, known as high-yield or “junk” bonds, carry higher interest rates to offset their increased risk.
Ratings significantly affect the quality, stability, interest rates, market appetite, and pricing of the bonds. Companies with solvency issues might offer income bonds, typically at higher rates, without the obligations for coupons or dividend payments.
How Corporate Bonds Are Sold
Corporate bonds are typically issued in blocks of $1,000 face or par value with standard coupon payment structures. Often, companies employ investment banks to underwrite and market bond offerings.
Investors receive consistent interest payments until the bond matures, retrieving the face value of the bond at maturity. Bonds may feature fixed interest rates or rates that adjust based on specific economic indicators. Some bonds incorporate call provisions, allowing for early repayment if market interest rates shift significantly.
Investors also have opportunities to trade bonds before maturity or invest in bond-focused mutual funds or ETFs.
Why Corporations Sell Bonds
Corporate bonds serve as debt financing and major capital sources for many businesses, alongside equity, bank loans, and credit lines. Often, bonds are issued to fund specific projects.
Debt financing can be more attractive than equity financing, often proving cheaper and devoid of ownership or control concessions. Companies with consistent earnings potential can issue debt securities to the public at favorable rates.
For short-term capital needs, companies may issue commercial paper maturing in up to 270 days.
Corporate Bonds vs. Stocks
Purchasing a corporate bond means lending money to a company, whereas buying stock means acquiring an ownership share of the company. Stocks’ value fluctuates, affecting the investor’s stake. Stocks can return profit through appreciation or dividends.
Bond investors earn interest and face minimal risk unless the issuing company fails. Even in bankruptcy, bondholders are prioritized over stockholders when debts are repaid.
Companies might also issue convertible bonds, which can change into company shares under certain conditions.
Are Corporate Bonds Better Than Treasury Bonds?
Choosing between corporate and Treasury bonds depends on the investor’s financial goals and risk tolerance. Corporate bonds generally offer higher interest due to their higher risk. Companies with lower risk profiles have bonds with lower rates compared to higher-risk companies.
Do Corporate Bonds Pay Monthly?
Most corporate bonds pay semi-annually, but payments could be monthly, quarterly, or yearly.
Are Corporate Bonds FDIC Insured?
Corporate bonds are not FDIC insured as they are investment securities, unlike insured deposit accounts.
The Bottom Line
Companies need capital for operations, and raising funds through equity or debt financing is financially prudent. Corporate bonds are a debt financing tool, allowing companies to raise capital without sacrificing ownership, thereby enabling more flexible operation.
Related Terms: Government bonds, Treasury Bonds, Convertible Bonds, Income Bonds, Credit Spread, Debt Financing.
References
- Fitch Ratings. “Rating Definitions”.
- Moody’s. “Rating Scale and Definitions”, Page 1.
- S&P Global. “S&P Global Ratings Definitions”.
