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The Ins and Outs of Investing in Corporate Bonds

The Ins and Outs of Investing in Corporate Bonds

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Corporate bonds are an investment instrument that pays higher rates than government (or municipal) bonds due to the increased risk of loss to bondholders. They have a wide range of conditions because the financial health of the issuers can vary greatly. Each company is different and has a different likelihood of defaulting on their obligations; however, they all use bonds for one reason: to raise money.

What Are Corporate Bonds?

When a corporation wants to raise money for some type of investment or expenditure, they have three basic choices. They can:

  1. Issue more stock
  2. Go to a lender and get a loan
  3. Issue bonds and take on more debt

The issuance of more stock may have implications for the value of the shares and could dilute ownership. The type of debt incurred (in the form of a short-term loan or a long-term mortgage which needs to be repaid with monthly installments) when going to a lender is not always ideal, and issuance of the loan may depend on the reason the corporation needs the money. Hence, issuing corporate bonds is a very common method of raising money.

Although issuing bonds is in effect going into debt, the terms and agreements of repayment through a bond structure may have tax advantages to the corporation. This is sometimes even viewed as a controlled growth measure if the purchase is in the forms of production equipment, or other assets which add to the corporation’s value.

Types of Corporate Bonds

There are four basic types of corporate bonds:

  • Secured bonds – bonds that are backed by real estate or equipment or an asset which can be liquidated to pay off the interest and principle of the bond.
  • Unsecured or “good faith” bonds – bonds that have no security other than the corporation’s reputation or word that what they present is true and that they will repay the principal and interest as stated.
  • Zero coupon bonds – bonds that have no interest payments prior to maturity.
  • Convertible bonds – bonds that can be converted for a specified amount of common or preferred stock of the corporation.

The terms and agreements, rates, and callability differ for each company and each offering. Additionally, there is a wide selection of bond structures, coupon rates, credit quality, and industry exposures that will affect the investment.

The Advantages of Corporate Bond Investing

There are several distinct advantages when investing in corporate bonds, which include the following:

  • If a bond is a convertible bond, it can be exchanged for a specified amount of common or preferred stock in the issuing company.
  • Most corporate bonds have a fixed coupon rate that doesn’t change until the time of maturity.
  • Corporate bonds usually pay a higher rate than municipal or government bonds.
  • They are generally good for people interested in investing in tax-deferred accounts or who are in a low tax bracket.
  • If a corporation goes bankrupt, or gets into financial distress, both bondholders and stockholders can make a claim on the company’s assets, however, bondholder claims take priority over those of stockholders.

The Disadvantages of Corporate Bond Investing

Some disadvantages when investing in corporate bonds may include the following:

  • Corporate bonds have a higher rate of risk of loss than municipal or government bonds.
  • They do not have the tax advantages of municipal or government bonds.
  • Corporate bonds have a wider range of ratings and yields because the financial health and well being of the corporations issuing the bonds vary.
  • The financial health of the corporation is directly reflected in the risk of loss of the investment made into the corporation.
  • Unlike stock, where shareholders own a share of the corporation, bondholders do not own shares or have any claim to ownership of the corporation.
  • Bondholders are, in essence, a creditor to the corporation; this means that they do not hold value in the corporation and must be treated like other creditors should financial problems arise.

The Language of Corporate Bonds

There is a unique language to corporate bond investing. Some additional key terms or phrases include:

  • Bond structures: the legal way the bond is structured or issued.
  • Callability or forced conversion: when a bond is called at the bequest of the issuing corporation.
  • Coupon rate: the interest rate stated on a bond, expressed as a percentage of the principal.
  • Floating rate: any interest rate that changes on a periodic basis. Sometimes called an adjustable rate.
  • Investment-grade rating: a rating given to the corporation to reflect its financial standing. The higher the rating, the more fiscally sound the corporation. Generally an “AAA” rating is the best and a “D” rating is the worst.
  • Maturity date: the date on which the bond becomes due for payment.

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