Understanding Corporate Bonds and How to Buy Them

Corporate bonds are debt obligations issued by companies looking to raise capital. When you purchase a corporate bond, you are in effect lending money to the corporation issuing the bond. In exchange, you receive interest payments at predetermined installments until the bond’s term expires. Once the bond reaches maturity, the corporation pays back the principal.

Relative to other investment options, highly rated corporate bonds are considered a fairly conservative investment choice. They are seen as less risky than investing in the stock market, but they can be more volatile than other fixed-income securities like U.S. government or municipal bonds.

Corporate bonds fall into different categories depending on their maturity, interest payments and credit rating.

Term lengths for corporate bonds can range from one to 30 years, but they are generally classified as short term (one to 3 years), medium term (four to 10 years), and long term (more than 10 years). Bonds with longer terms usually offer higher interest payments to entice investors to tie up their money for an extended period. However, it’s essential to remember that long-term bonds are more likely to encounter changes in value due to fluctuations in interest rates and other market conditions, so more significant risk can be involved.

Before issuing a bond, corporations must confirm how they pay interest to their bondholders. The interest rate established is referred to as the coupon rate. Fixed-rate bonds will pay the bondholder the same amount of interest each year until maturity. The coupon payments are made at predetermined dates throughout the year (semi-annual coupon payments are the most common).

Floating-rate bonds can see their coupon rate adjusted periodically according to fluctuations in market interest rates. These bonds are tied to a specific index and will mirror 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 to the bondholder. Instead, these bonds are sold at a steep discount, and the bondholder benefits when they receive the higher face value at maturity. For example, say you paid $4,000 for a five-year zero-coupon bond with a face or par value of $5,000. When the bond matures, the issuer will pay you $5,000, the sum of your original purchase price plus the discount amount.

Similar to a credit check when you apply for a loan, corporations looking to issue bonds to investors must undergo a review by a rating agency. Historically, the three most prominent bond-rating agencies are Fitch, Moody’s and Standard & Poor’s. These agencies assess a corporation’s financial strength to determine its creditworthiness. Then, based on each corporation’s financial standing and susceptibility to adverse economic conditions, the agencies estimate the likelihood of the corporations meeting their financial obligations on time and assign them a letter grade.

Bond ratings fall into two main categories: investment grade and non-investment grade. Investment-grade bonds are of higher quality, typically viewed as very likely to pay their bondholders on time. Non-investment-grade bonds (also known as high-yield or “junk” bonds) are less likely to meet their debt obligations and therefore carry greater risk. Bonds that receive a non-investment-grade rating usually offer higher coupon rates to compensate investors for taking on more risk.

Corporate bonds with the best financial standing are rated “triple-A,” meaning they are most likely to meet their debt obligations to investors and thus carry the lowest amount of risk. From there, the grades descend according to the perceived quality of the bond and the level of risk involved:

Buying a corporate bond is different from investing in company stock in that bondholders do not own equity in the company. Corporate bonds are typically issued in blocks with a face or par value of $1,000. Bondholders collect interest payments at predetermined dates according to the terms of the bond.

Most corporate bond trading occurs in the secondary market, also known as the over-the-counter (OTC) market. This means investors must use a broker or dealer to facilitate the purchase or sale of a bond. Bonds are often traded at either a premium or a discount relative to their par value. Typically, bond prices are negatively correlated to fluctuations in market interest rates, meaning that when interest rates rise, bond prices fall, and when interest rates fall, bond prices rise.

An essential calculation in determining a bond’s value is its yield to maturity. 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 to compare how premiums and discounted bond prices affect the value of a bond, take a look at the examples below:

Bond X is trading at par value. An investor holding it will collect annual 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 trading at a $70 discount to its face value. This would typically mean that market interest rates for bonds with similar maturities are higher than the 3% coupon rate for Bond Y. To attract a buyer for a bond with lower interest payments, this bond has been listed at a discounted price. An investor holding Bond Y will receive the same $30 interest payment each year, but at maturity, the bondholder will receive the $1,000 face value of the bond. Since Bond Y was purchased at a discount, its yield to maturity is higher, making it an attractive option despite the coupon rate being lower than the larger market.

Bond Z is trading at an $80 premium relative to its $1,000 face value. This would usually indicate that interest rates for bonds with similar maturities have fallen during the holding period. If Bond Z’s coupon rate is higher than other available bonds, investors would be willing to pay more than face value on the OTC market to get the higher interest payments. An investor who purchased Bond Z for $1,080 will still receive the $30 interest payment each year and will benefit from owning a bond with better interest rates than other available bonds. At maturity, the bondholder would receive the $1,000 face value, $80 less than the purchase price. Because the bond was purchased for more than its face value, it negatively affects the yield to maturity for Bond Z.

As with any investment product, corporate bonds carry some level of risk. Corporate bonds that hold more risk will typically have more attractive coupon rates, so investors looking to invest in the bond market must weigh the risk and reward of purchasing a given bond.

Default risk: There is always the chance a corporation that has issued a bond cannot afford its interest payments to bondholders. While this is less likely for investment-grade corporate bonds, adverse market conditions could negatively impact a company enough not to pay its debt obligations.

Interest rate risk: Corporate bonds are also exposed to risks tied to interest rates. If rates rise, it may be challenging to sell a bond you own 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: Corporate bonds with longer terms have more inflation risk. As inflation increases, you risk losing purchasing power over time. (Dig deeper into purchasing power with our inflation calculator.)

Call risk: Some bonds are issued with call provisions, which would allow the company that issued the bond to purchase the bonds back from investors if interest rates and bond prices become unfavorable for the corporation.

Newly issued corporate bonds are sold on the primary market, where you can buy them directly from the issuer at face value. New-issue bonds are sold in blocks of $1,000 per bond, so it can be expensive to build a diversified bond portfolio and appropriately mitigate risk. For investors who may not have the capital to buy multiple bonds on the primary market, there are other ways to invest in corporate bonds:

1. From an online broker: You can purchase corporate bonds on the secondary (OTC) market through a broker. Bonds available for purchase on the secondary market are owned by other investors looking to sell. You may be able to find bonds selling at a discount due to interest rate movement or other economic factors affecting the bonds’ price.

2. Exchange-traded funds: Corporate bond ETFs hold bonds from several different companies simultaneously. Funds may focus on bonds with specific maturities, credit ratings or exposure to certain market sectors. ETFs allow investors to gain exposure to the corporate bond market that is already diversified within the fund and for much less than it would cost to purchase individual bonds on your own.

Corporate bonds may appeal to investors looking to diversify their assets. If you’re thinking about investing in corporate bonds and are unsure which option might be best, speak with your financial advisor to help guide your decision.