Corporate Bonds: 4 Risks, 3 Benefits & 3 Types You Can Invest in

By Chika


Last Updated: February 15, 2023


Similar to individuals, companies frequently need to borrow money to finance new endeavors, pay off existing obligations, or even acquire another company. One option available to them is to issue bonds. 

Corporate bonds provide investors with a stream of income that is more stable and lucrative than stock dividends, as interest payments are often fixed. However, bonds are a dangerous kind of investment, since the issuing corporation might default.

This article examines corporate bonds, their benefits and shortcomings, and why you may want to include them in your portfolio.



What are Corporate Bonds?

Corporate bonds are debt security issued by companies and sold to investors.

The company receives the capital in exchange for a certain amount of interest payments at a fixed or variable interest rate. At the bond's expiration, or "maturity," interest payments cease and the initial investment is refunded.

Companies utilize the capital from bond sales for several objectives, including:

  • purchasing new equipment
  • investing in research and development
  • buying back their shares
  • paying shareholder dividends
  • refinancing debt
  • funding mergers

The backing for the bond is often the company's capacity to repay, which depends on its future revenue and profit projections. In certain instances, the company's tangible assets may serve as collateral.

Corporate bonds are often thought to be riskier than U.S. government bonds. As a result, interest rates on corporate bonds are virtually always higher, even for corporations with the highest credit ratings. 



3 Types of Corporate Bonds

Corporate bonds are classified into groups using various metrics.

1. Maturity

Bonds can be categorized based on their maturity -  the date by which the issuer must return the principal to investors.

  • Short-term (less than three years)
  • Medium-term (four to ten years)
  • Long-term maturities are all possible (more than 10 years).

Typically, longer-term bonds provide greater interest rates, but they may also carry more risks.


2. Credit rating

Bonds and their issuing companies are also categorized according to their creditworthiness.

Credit ratings are assigned by rating agencies based on their assessment of the risk that a firm would fail on its debts. Credit rating firms assess their bond ratings regularly and may adjust them if circumstances or expectations change.

Bonds can be investment grade or non-investment grade depending on their credit ratings.

The timely payment of investment-grade bonds is seen as more likely than that of non-investment-grade obligations. Non-investment-grade bonds, often known as high-yield or speculative bonds, typically provide higher rates of interest to compensate investors for the additional risk they assume.


3. Interest payment

Bonds may vary in terms of the interest payments they provide.

Many bonds pay a set interest rate for the duration until they mature. These are called fixed-rate bonds. 

Some bond types regularly reset variable interest rates, such as every six months. These bonds are known as floating rate bonds (or floating rate notes). Their interest rates are modified in response to fluctuations in market interest rates.

There are also zero-coupon bonds.

Interest payments are called coupon payments, and the interest rate is called the coupon rate. The zero-coupon bond does not pay interest until its maturity date. Since no coupon payments are made, the bond matures with a single payment that exceeds the initial purchase price.

Let's say an investor buys a 5-year zero-coupon bond with a $1,300 face value for $1000. The corporation pays no interest on the bond for the following five years and then pays $1,300 at maturity, which is equivalent to the bond's acquisition price of $800 plus interest, or initial issue discount, of $300.


Corporate Bond Ratings

Bonds are examined for the creditworthiness of the issuer by one or more of the three U.S. rating agencies - Standard & Poor's Global Ratings, Moody's Investor Services, and Fitch Ratings before being released to investors.

The highest-graded bonds are often referred to as "Triple-A" rated bonds, while each rating organization has its ranking system. The lowest-rated corporate bonds are referred to as high-yield bonds since they carry a higher interest rate to compensate for their greater risk. These are also known as junk bonds.

Bond ratings are essential for informing investors about the quality and stability of a certain bond. Consequently, these ratings have a substantial impact on:

  • interest rates
  • investment appetite
  • bond prices



3 Benefits of Investing in Corporate Bonds

1. Attractive yields

Because corporate bonds have a greater credit risk than government bonds, they typically provide highly attractive rates. While average yields fluctuate according to the economic cycle, investment-grade corporate bonds typically provide two to three percentage points higher rates than US Treasury bonds.


2. Diversification

Investors can diversify their portfolios by purchasing corporate bonds.

Typically, debt instruments such as bonds serve as a counterweight to equities, moving in the opposite direction of equities. Corporate bonds can mitigate the increased risk associated with investing in stocks of firms with aggressive growth objectives.


3. Capital gains

Even though corporate bonds are generally income investments, investors can nevertheless speculate with them. Because bond values can fluctuate based on interest rates and economic situations, corporate bonds might give profit chances during tumultuous periods.

This is especially true for junk bonds, which historically have moved more like stocks than low-risk corporate bonds. Since the outbreak of the coronavirus pandemic, the link between junk bonds and stocks has risen, buoyed by the Federal Reserve's commitment to buy corporate bonds.



4 Risks Associated with Corporate Bonds

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


1. Credit risk

Credit or default risk implies the chance of the firm falling into financial difficulties, impeding its capacity to make bond interest and principal payments. If a corporation fails, bond investors may incur losses.


2. Call risk

Some corporate bonds have a call provision that allows the issuing corporation to repurchase the bonds at face value before maturity.

This is especially problematic for investors in instances where interest rates have declined and bond prices have increased since it would prevent them from earning a profit by selling their bonds on the open market.

Moreover, you lose the bond's interest and may not be able to locate another with a comparable rate.


3. Liquidity risk

Historically, the bond market lacked the price transparency of the stock market.

This poses a greater concern for bonds issued by private corporations or smaller enterprises that trade over the counter. Larger corporations' investment-grade bonds are less likely to experience this difficulty.


4. Interest/inflation risk

This is a systemic risk that every fixed-interest bond faces. As interest rate increases, this will cause the market value of bonds to decline. Additionally, there is the issue of inflation, which might diminish the value of interest payments and the face value of a bond approaching maturity.

In general, the longer the maturity of the bond, the greater its exposure to these risks; hence, longer-term bonds pay a higher interest rate.



How to Buy Corporate Bonds

You can buy corporate bonds on the primary market through a brokerage firm, bank, bond trader, or broker.

Some corporate bonds are traded on the over-the-counter market and offer good liquidity. You can also buy corporate bonds through bond funds. This allows you to spread the risk since a fund contains different bonds. It is also cheaper than buying an individual corporate bond. 



What Happens if a Company Goes into Bankruptcy?

If a company stops paying on its bonds and then goes bankrupt, the bondholders will have a right to the assets and cash flows of the company.

The position of the person who owns the bond is set by the terms of the bond. Priority will depend on the type of bond, such as whether it is a:

In the case of a secured bond, the company puts up real estate, machinery, or other company-owned assets as collateral to back up the bond. In the event of a default, holders of secured bonds will have the legal right to foreclose on the collateral to get their money.

Unsecured bonds, which are also called debentures, do not come with any security.

Debentures have a broad claim on the assets and cash flows of the corporation. They can be senior debentures or junior (subordinated) debentures. If the company goes bankrupt, holders of senior debentures will have a bigger claim on the assets and cash flows of the company than holders of junior debentures.

But bondholders are not usually the only people who owe money to the company. The company may owe money to banks, suppliers, customers, retirees, and others in addition to bondholders. Some of these people or groups may have the same or even more rights than bondholders.

In bankruptcy court, the different claims of creditors are sorted out through a complicated process.

Photo by Anna Shvets


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