How Corporate Bonds Work
Think of it like this: A corporate bond is like an IOU that a company gives you in return for money you lend the business. It’s a contract to pay you back at a certain rate of interest at a certain period. The alternative for companies is to engage in an initial public offering and raise equity by selling stocks. This is a long and expensive procedure. Selling bonds, while still complicated, is easier. It’s a quicker way to raise capital for corporate expansion. You can buy corporate bonds individually or through a bond fund from your financial advisor. They are riskier than government bonds because there’s a chance the company can go bankrupt and default on the bond. Corporate bonds are rated according to their risk by ratings agencies such as Moody’s, Standard & Poor’s, and Fitch. The higher the risk, the higher the return the corporation must offer in order to attract borrowers. Most corporate bonds offer a fixed interest rate to the bond purchaser. If you hold the bond to maturity, you will receive the principal plus the sum of all the interest paid. That’s your total return or yield. But if you sell the bond before maturity, you may not get the same price back that you paid for it. The value of your bond will drop if interest rates on other bonds go up. Why would someone pay you the same if your bond has a lower interest rate than the others that are available? In that case, your total return or yield will drop. That’s why they always say bond yields fall when interest rates rise.
U.S. Bond Trading Volume
The graph below illustrates the U.S. Bond trading volume from 1996-2020, broken down by Treasurys, mortgage-backed securities, corporate debt, municipal bonds, and federal agency securities.
Types of Corporate Bonds
There are many different types of corporate bonds, which vary by risk and return. They can be categorized by the bond’s duration, risk, and interest rate.
Duration
The first category is the duration. This refers to how long it will take for the bond to mature. There are three lengths of duration:
Short-term: Set to mature in three years or less, these bonds were once considered the safest, because they were held for less time. But in a period of rising interest rates, some bonds depreciate in value. Medium-term: The term on these bonds is four to 10 years. The Fed purchases these when it sees the need to stimulate the economy through quantitative easing. Long-term: With terms of more than 10 years, longer-term bonds usually offer higher interest rates because they tie up lenders’ money for a decade or more. This makes the yield, or overall return, more sensitive to interest rate movements.These bonds are sold with a call, or redemption provision. Longer-duration bonds may have terms that allow the issuing company to redeem them after a certain number of years if interest rates are lower. That allows the company to pay off your bond with funds from a new, cheaper bond.
Risk
The second category is risk, which can be broken down in two ways. Investment-grade bonds are issued by companies that are considered unlikely to default. Most corporate bonds are investment grade. These are attractive to investors who want more return than they can get with Treasury notes. They’re rated at least Baa by Moody’s and at least BBB- by Standard & Poor’s and Fitch Ratings. High-yield bonds, also known as junk bonds, offer the highest return. But they are the riskiest. In fact, the rating of “not investment grade” should be a warning. These are considered downright speculative. These bonds rate a Ba or lower by Moody’s, or BB or below by S&P and Fitch).
Interest Payment
The third category is based on the type of interest payment. There are four possibilities.
Fixed-rate, also called plain vanilla, are the most common. You will receive the same payment, called a coupon payment, each month until maturity. The interest rate is called the coupon rate. Back in the old days, investors actually had to clip the coupons on the paper bond and send them in to get paid. Now, of course, it’s all done electronically. Floating-rate bonds reset their payments periodically, such as every six months. The payments change based on changes in other market interest rates, such as the Treasury rate. Zero-coupon bonds withhold interest payments until maturity. But the investor must pay taxes every year on the accrued value of the interest payment, just as if they were being paid. Convertible bonds are like plain vanilla bonds, but these allow you to convert them to shares of stock. If stock prices rise, the value of the bonds will increase. If stock prices fall, you still have the bond coupons and the original bond value if you hold until maturity. Since these bonds have this added advantage, they pay lower interest rates than plain vanilla bonds.
Speculative-grade bonds have six grades ranging from Ba to C (Moody’s) and BB to D (S&P). The top level is somewhat speculative while the lowest two grades convey imminent default and default.
