Corporate Bonds: Definition and How They're Bought and Sold

What Are Corporate Bonds?

Corporate bonds serve as a vital instrument for businesses seeking capital to finance a range of activities like growth initiatives, bill payments, capital improvements, and acquisitions. These bonds, debt securities issued by corporations, offer an investment opportunity wherein the company receives needed capital while investors earn a pre-established interest on their investment.

Upon reaching maturity, the bond ends, and the original investment returns to the investor. The ability of the corporation to repay the bond typically supports these bonds, relying on the company's future revenue prospects and overall profitability. Sometimes, a company may also secure a bond with its tangible assets.

Assessing the Value and Risk of Corporate Bonds

High-quality corporate bonds are considered relatively safe and conservative investments. Investors building balanced portfolios often add bonds in order to offset riskier investments such as growth stocks.

Over a lifetime, these investors tend to add more bonds and fewer risky investments in order to safeguard their accumulated capital. Retirees often invest a larger portion of their assets in bonds in order to establish a reliable income supplement.

In general, corporate bonds are considered to have a higher risk than U.S. government bonds. Thus, corporate bonds usually have higher interest rates, even for companies with excellent credit.

Deciphering Corporate Bond Ratings and Their Impact

Before being issued to investors, bonds are reviewed for the creditworthiness of the issuer by one or more of three U.S. rating agencies: Standard & Poor's Global Ratings, Moody's Investor Services, and Fitch Ratings.

Each has its own ranking system, but the highest-rated bonds are commonly referred to as "Triple-A" rated bonds. The lowest-rated corporate bonds are called high-yield bonds due to the greater interest rate applied to compensate for their higher risk. These bonds are also called "junk" bonds.

Bond ratings inform investors about bond quality and stability and influence interest rates, investment demand, and bond pricing.

Companies with solvency problems, those trying to avoid bankruptcy, and those in reorganization might also offer income bonds, usually at an above-average rate. Income bonds can raise money for the struggling company and are not required to pay coupons or dividend payments.

Navigating the Corporate Bond Market: Issuance and Trading

Corporate bonds are issued in $1,000 blocks called par value, and they usually have a standard coupon payment structure. Typically a corporate issuer will enlist the help of an investment bank to underwrite and market the bond offering to investors.

The investor receives regular interest payments from the issuer until the bond matures. At that point, the investor reclaims the face value of the bond. The bonds may have a fixed interest rate or a rate that floats according to the movements of a particular economic indicator.

Corporate bonds may have call provisions for early prepayment if interest rates change significantly, allowing companies to issue better bonds.

Investors may also opt to sell bonds before they mature. If a bond is sold, the owner may get more or less than face value, depending on the bond prices, interest rates, and the number of payments still due before the bond matures.

Investors may also gain access to corporate bonds by investing in any number of bond-focused mutual funds or ETFs.

Motivations Behind Corporate Bond Issuance

Corporate bonds are a form of debt financing. They are a major source of capital for many businesses, along with equity, bank loans, and lines of credit. They often are issued to provide the ready cash for a particular project the company wants to undertake.

Equity financing involves issuing stocks, while debt financing involves issuing bonds. Corporate bonds help companies raise capital without losing ownership, enabling freer operation. Debt financing can be preferable to equity financing because it's usually cheaper and doesn't require losing ownership or control.

Generally speaking, a company needs to have consistent earnings potential to be able to offer debt securities to the public at a favorable coupon rate. If a company's perceived credit quality is higher, it can issue more debt at lower rates.

When a corporation needs a very short-term capital boost, it may sell commercial paper, which is similar to a bond but typically matures in 270 days or less.

Comparing Corporate Bonds and Stocks: Key Differences

An investor who buys a corporate bond is lending money to the company. An investor who buys stock is buying an ownership share of the company.

The value of a stock rises and falls, and the investor's stake rises or falls with it. The investor may make money by selling the stock when it reaches a higher price, by collecting dividends paid by the company, or both.

By investing in bonds, an investor is paid in interest rather than profits. The original investment can only be at risk if the company collapses. One important difference is that even a bankrupt company must pay its bondholders and other creditors first. Stock owners may be reimbursed for their losses only after all of those debts are paid in full.

Companies may also issue convertible bonds, which are able to be turned into shares of the company if certain conditions are met.

The Bottom Line

Companies need money to run their businesses. Even if they generate enough money through their core operations, it can be financially prudent to raise outside money. Companies generally have two options for doing this: equity financing and debt financing.

Equity financing is the issuance of stocks, and debt financing includes the issuance of bonds. Corporate bonds allow companies to raise capital without giving up ownership and to operate more freely.