Both public and private corporations issue corporate bonds, which are a type of fixed-income security. Corporations place these investments on the open market to help fund projects and other major financial undertakings. Investors can purchase a corporate bond on either the primary or secondary markets, and they offer predictable payouts and strong liquidity. If you have questions about how corporate bonds could fit into your portfolio, consult with a financial advisor.
What Is a Corporate Bond?
Corporate bonds are one of many different types of bonds. Essentially, they are a debt obligation that’s being offered by companies to investors as a loan. Bonds are one of the two main types of corporate securities you can invest in. The other, stocks, represent buying a small portion of ownership of the actual company, while bonds are loaning your money to the company.
Bonds are generally less risky than stocks, as they are not subject to the whims of the stock market. In turn, bonds generally have less of a chance for a big return than stock investments. However, as you near retirement, this low-risk investment type may be more attractive than a volatile stock.
As you look into buying corporate bonds, keep an eye out for how well rated each bond’s issuer is. Similar to your personal credit score, a corporation offering a corporate bond will have its financial stability accounted for in the bond rating. Moody’s, Fitch and Standard & Poor’s (S&P) are the main rating agencies, with “investment-grade” and “non-investment-grade” being the two overarching categories for these scores. Non-investment-grade bonds may also be referred to as “junk bonds.”
Types of Corporate Bonds
Corporations do not directly offer corporate bonds. On the other hand, they work with investment bankers and other financial institutions to get their bonds on either the primary or secondary markets. Although there are many subcategories of corporate bonds, here are some of the most common:
Fixed-Rate Corporate Bonds
Fixed-rate corporate bonds provide consistent interest returns on a monthly, quarterly, bi-annual or annual basis. Which payout schedule your investment receives depends on the bond you buy, though the interest rate never changes. The size of these payments is dictated by a set percentage of your bond’s par value, which is what its worth will be at the time of ultimate maturity. More specifically, a $1,000 corporate bond with a 7% fixed rate would pay $70 a year.
Variable-Rate Corporate Bonds
In opposition to fixed-rate bonds, variable-rate corporate bonds shift their interest rates around once every year. These do not abide by an arbitrary percentage, but rather they’re aligned with a certain interest rate benchmark. This could end up being any number of benchmarks, such as the U.S. prime rate, the London Inter-bank Offered Rate or LIBOR, which will be phased out June 30, 2023 and the Secured Overnight Financing Rate (SOFR). Although these have slightly less reliability than fixed-rate bonds, they have the potential for better return upside.
Zero-Coupon Corporate Bonds
Whereas most corporate bonds include regular interest payments, zero-coupon bonds pay out solely on their final maturity date. In turn, you can usually buy them at a cheaper price. While a discount might seem desirable, the long-term style of zero-coupon corporate bonds leave them susceptible to volatility.
Pros and Cons of Corporate Bonds
Fixed-income securities are famous for their ability to maintain stable returns, albeit low ones. Corporate bonds, however, offer one of the best return prospects of any fixed-income option. In a way, they’re sort of similar to investing in a company’s stock. But unlike equities, corporations must pay back the principal and interest of their bonds before that of its stock shares. This priority affords corporate bonds a certain sense of safety, even with their potentially impressive returns.
Despite what’s beneficial about corporate bonds, there are plenty of risky characteristics to watch for. Because corporations need to make money to pay back the bonds they issue, be aware that they may default on their payments under certain circumstances. This could be due to changing factors within the economy, federal and state regulations, the overall market and more.
Interest rates and corporate bonds have an inverse relationship. As interest rates rise, the prices of preexisting bonds will drop. If rates fall, though, bond prices are likely to rise, causing investors to sell their holdings. Should the second situation occur, the bond’s issuer may choose to call. This means the corporation will pay off the bond early in order to save money, resulting in possible financial losses for investors.
How to Buy Corporate Bonds
There are two main classes of corporate bonds: new issue and secondary market/over-the-counter (OTC). New issue corporate bonds are freshly created and available through the primary market for a fixed initial offering price. By contrast, the secondary market/OTC options consist of the leftovers of the primary market.
The primary market is exclusive and almost always calls for some sort of established relationship with a financial institution. This high-level nature makes new issue bonds difficult to reach for anyone but financially-privileged investors. Those who don’t match this description should look into a brokerage firm when they want to purchase corporate bonds, as they typically only dabble in secondary market/OTC offerings. This is ideal for the average investor, but their high-end counterparts should focus on entering the primary market.
Brokerage accounts represent some of the best investment autonomy, which can make them extremely attractive. Even if corporate bonds are in your crosshairs, you can also buy stocks, mutual funds and more through a broker. Here are a few firms you may want to consider:
|Corporate Bond Trading Fees
|$1 per online trade
|– Online traders
– Investment veterans and newbies alike
|$1 per online trade
|– Bank of America account holders
– Customer support users
|$1 per online trade
|– Active and experienced traders
Direct purchases of corporate bonds are not the only way to invest in them. In fact, there are many exchange-traded funds (ETFs) and mutual funds that center around these types of bonds. The benefit of buying into a corporate bond mutual fund or ETF is that they are inherently diversified. In other words, they will automatically spread your money throughout the market at a fraction of the cost that it would require to do so individually.
Financial advisor firms usually utilize their own proprietary investment strategies when working with clients. Because of this, you’ll likely come across a firm that includes corporate bonds in their portfolios. So if you have reservations about purchasing these bonds by yourself, this could be a worthwhile alternative.
Everything comes with its downsides, though, and financial advisors are no different. Because advisory services customarily include full professional management, their costs are often higher than that of brokers. This could be worthwhile, though, as most firms not only will aid you in formulating a collection of investments, but they’ll also create a complete financial plan.
Corporate Bonds vs. Municipal Bonds and Stocks
Stocks often carry a large amount of risk, as their value is based on the financial performance of a company. Investors are rewarded for stomaching this, though, as the possible earnings of equities are unparalleled. Corporate bonds capture this on a much smaller scale, although their typical risk is significantly lower. If you can handle the stress of high-risk investing in the hopes of strong returns, stocks are the way to go. But for anyone that prefers low-cost, secure returns, corporate bonds are worth looking into.
Bonds come in many variations, and municipal bonds, or munis, are one of the most prominent. State, county, city and other government institutions issue munis to the public to fund work for infrastructure improvements and other projects. When it comes to interest yield, corporate bonds have the superior returns. However, taxes play a major part in this comparison, as munis are exempt from federal income taxes and sometimes even state and local taxes. Corporate bonds do not have this perk, meaning that taxes could nix their superior returns.
Fixed-income securities boast plenty of reliability, but this is especially true of municipal bonds. As you might expect from a government-backed security, the credit ratings for munis are great and they rarely end in defaults. Businesses are much riskier ventures than government entities, so corporate bonds simply do not have the same features. To ensure that you choose the right type of bond for you, weigh the above considerations carefully.
Rather than thinking of certain investments as “good” or “bad,” try viewing them as a better fit for some people than others. For example, fixed-income securities are best for risk-averse investors who prefer on-time interest payments over the fluctuating returns of equities.
Generally speaking, corporate bonds fall right in line with this description. However, because they can be tough to attain for lower-level investors, corporate bonds are not as readily available as other fixed-income investments.
Tips to Improve Your Investments
- Financial advisors work in the investment sphere day in, day out and, as a result, have ample experience building investment portfolios for specific purposes. Luckily, finding the right financial advisor doesn’t have to be hard. SmartAsset’s free matching tool can connect you with up to three financial advisors who serve your area. You can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Devising a specific asset allocation is an integral part of planning your investment portfolio. This involves dividing your money across different investment types so that the success of your portfolio is not overly dependent on one area of the market. SmartAsset’s asset allocation calculator can help simplify this investing principle.
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