Nerdy takeaways
- A corporate bond is a loan to a company. Investors receive interest until the bond matures and the principal is repaid.
- Corporate bonds tend to be a less risky investment than stocks but involve more risk than Treasury or municipal bonds.
- Corporate bonds vary in their maturity, interest payments and credit rating.
- Bond prices are negatively correlated to market interest rates. When interest rates rise, bond prices fall, and vice versa.
A corporate bond is a debt obligation that a corporation sells to investors in exchange for cash. It is similar to an IOU or a loan in that the investor receives periodic interest payments from the corporation. At the end of the bond term (maturity), the corporation repays the original principal.
- Companies typically issue corporate bonds in order to raise cash.
- In general, there are two ways investors can make money on corporate bonds: by collecting the interest payments over time and by selling the bond to another investor at a profit.
- Investors typically consider corporate bonds less risky than stocks. However, the value of corporate bonds can be more volatile than other fixed-income securities such as U.S. government or municipal bonds.
You can buy and sell corporate bonds. Most corporate bond trading occurs in the secondary market, also known as the over-the-counter (OTC) market. This means investors use a broker or dealer to buy and sell bonds. Bonds often trade either a premium or a discount relative to their par value.
Typically, bond prices are negatively correlated with interest rates, meaning that when interest rates rise, bond prices fall, and when interest rates fall, bond prices rise.
How do corporate bonds work? The basics
Three of the most important characteristics of corporate bonds are maturity, interest rate and credit rating.
Maturity
A bond's maturity is its lifespan. Maturities for corporate bonds can range from one to 30 years. Bonds with longer terms usually offer higher interest payments to entice investors to tie up their money for an extended period. However, long-term bonds may be more likely to fluctuate in value due to fluctuations in interest rates, the company’s creditworthiness and other market conditions. Accordingly, long-term corporate bonds may carry more risk than shorter-term corporate bonds.
» MORE: How bond ladders work
Interest rate
When you buy a corporate bond, you essentially become one of the company’s lenders.
- The interest rate on a corporate bond is called the coupon rate.
- The coupon payments are made at predetermined dates throughout the year (semi-annual coupon payments are the most common).
Corporate bonds that are riskier typically have higher coupon rates, so investors must carefully weigh the risk and reward of purchasing a given bond.
Credit rating
Corporate bond issuers typically undergo a review by a rating agency that evaluates the company’s creditworthiness. Historically, the three most prominent bond-rating agencies are Fitch, Moody's and Standard & Poor's.
Based on the corporation's financial condition and susceptibility to adverse economic conditions, the agencies estimate the likelihood that the corporation will make the interest and principal payments on time. The ratings agencies then give them a letter grade. The letter grades fall into two main buckets: investment grade and non-investment grade (more on that below).
Types of corporate bonds
- Short-term bonds mature in one to three years.
- Medium-term bonds mature in four to 10 years.
- Long-term bonds mature in more than 10 years.
- Fixed-rate bonds pay the bondholder the same amount of interest each year until maturity.
- Floating-rate bonds adjusted their coupon rates periodically according to fluctuations in market interest rates. The rate is usually tied to a specific index and mirrors the movement of that index. For example, the floating rate might be tied to a particular rate or bond index plus 1%.
- Zero-coupon bonds do not make regular interest payments. Instead, the company sells the bonds at a steep discount, meaning the investor pays a relatively small amount for the bond and then gets one relatively large payment at maturity. For example, you might pay $4,000 for a five-year zero-coupon bond with a face or par value of $5,000. This means you pay $4,000 now to get $5,000 in five years.
- Investment-grade bonds are bonds from issuers that are very likely to pay their bondholders on time.
- Non-investment-grade bonds (also known as high-yield or "junk" bonds) are bonds from issuers that are less likely to meet their debt obligations and therefore carry greater risk. These corporate bonds usually offer higher coupon rates to compensate investors for taking on more risk.
- Municipal bonds are bonds that local governments issue to finance public projects such as roads, bridges, fire departments, libraries and schools. Municipal bonds can offer a way to generate tax-free interest income.
- Savings bonds are issued by the U.S. Treasury and are loans to the U.S. government. There are two types: series EE and series I.
- Treasury bonds are government bonds that mature in 20 or 30 years. Treasury notes mature in two, three, five, seven or 10 years.
» MORE: How Treasurys work
Corporate bond ratings
The best corporate bonds are rated "triple-A," meaning they are most likely to meet their debt obligations to investors and thus carry the lowest risk. From there, the grades descend according to the perceived quality of the bond and the level of risk involved.
Investment-grade bond ratings | |||
Moody's | Standard & Poor's | Fitch | What the grade means |
Aaa. | AAA. | AAA. | Highest quality, minimal risk. |
Aa. | AA. | AA. | High quality, very low risk. |
A. | A. | A. | High/Medium quality, low credit risk. |
Baa. | BBB. | BBB. | Medium grade, moderate credit risk. |
Non-investment-grade bond ratings | |||
Moody's | Standard & Poor's | Fitch | What the grade means |
Ba. | BB. | BB. | Substantial credit risk. |
B. | B. | B. | High credit risk. |
Caa. | CCC. | CCC. | Low quality, very high credit risk. |
Ca. | CC. | CC. | In or near default, some prospect of recovery. |
C. | C. | C. | Moody's lowest rating, typically in default with little prospect of recovery. |
C. | D. | D. | In default, also used when bankruptcy has been filed. |
Yield to maturity
An essential calculation in determining a bond's value is its yield to maturity (YTM). YTM calculates the annual return on a bond if it is held to maturity, but it also factors the bond price and date of purchase. The calculation for YTM is relatively complex, but take a look at these three sample bonds:
Bond X | Bond Y | Bond Z | |
|---|---|---|---|
Price | $1,000 (par value). | $930 (discount). | $1,080 (premium). |
Maturity | 5 years. | 5 years. | 5 years. |
Face value | $1,000. | $1,000. | $1,000. |
Coupon rate | 3%. | 3%. | 3%. |
Yield to maturity | 3%. | 4.58%. | 1.34%. |
- Bond X is trading at par value. The investor gets interest payments of $30 every year until the bond reaches maturity, at which point the bondholder receives the $1,000 principal back.
- Bond Y is cheaper to purchase; it’s trading at a $70 discount to its $1,000 face value. Usually this happens when interest rates on other bonds with similar maturities are higher than the 3% coupon rate that Bond Y pays. Buyers are less willing to buy this bond, which is why it’s trading at a discount. An investor holding Bond Y gets the same $30 interest payment each year and the same $1,000 at maturity. Since Bond Y was purchased at a discount, its yield to maturity is higher, making it an attractive option for some investors.
- Bond Z is more expensive; it's trading at an $80 premium relative to its $1,000 face value. Usually this happens when interest rates on other bonds with similar maturities are lower than the 3% coupon rate that Bond Z pays. Buyers are more willing to buy this bond, which is why it’s trading at a premium. An investor holding Bond Z gets the same $30 interest payment each year and the same $1,000 at maturity. Because the bond was purchased for more than its face value, it has a lower yield to maturity than Bond Y.
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Risks of corporate bonds
Corporate bonds carry four main types of risks.
- Default risk: This is the risk that the corporation can’t afford to make its interest payments to bondholders. This risk is lower for investment-grade corporate bonds, though adverse market conditions could negatively affect any company enough to jeopardize its ability to make debt payments.
- Interest rate risk: This is the risk that market interest rates rise so much that your bond’s coupon rate looks relatively tiny and thus makes it much less valuable if you want to sell it on the secondary market. In addition, bonds far from their maturity date carry more interest rate risk, as rates are more likely to rise and fall over long periods.
- Inflation risk: This is the risk that you lose purchasing power over time. Corporate bonds with longer terms have more inflation risk. (Dig deeper into purchasing power with our inflation calculator.)
- Call risk: This is the risk that the company essentially pays off the bond early by forcing you to sell the bond back to it before maturity. Corporations sometimes do this if interest rates and bond prices become unfavorable for the corporation.
How to buy corporate bonds
You can buy new corporate bonds directly from the issuer at face value. These new-issue bonds are usually sold in blocks of $1,000 per bond, so it can be expensive to build a diversified bond portfolio and appropriately mitigate risk.
If you don’t have enough money to buy a bunch of bonds on the primary market, there are other ways to invest in corporate bonds:
- With the help of a financial advisor. Corporate bonds are one of many ways to diversify a portfolio. If you're thinking about investing in corporate bonds and are unsure which option might be best, speak with a financial advisor.
- From a broker: You can buy corporate bonds on the secondary market through a brokerage account. Bonds available for purchase on the secondary market are owned by other investors looking to sell.
- Exchange-traded funds (ETF): Corporate bond ETFs are pools of bonds from several different companies. Investing in a bond ETF often costs much less than it would to buy a bunch of individual bonds on your own. Some TFs may focus on bonds with specific maturities, credit ratings or exposure to certain market sectors.
» Need a pro to help add bonds to your portfolio? See our list of the year's best financial advisors
