Corporate Bonds

Most investors who hold bonds do so via an aggregate bond index mutual fund or exchange-traded fund (ETF). These funds aim to track the broad universe of investable bonds, holding everything from Treasury bonds, mortgage-backed securities, agencies bonds and corporate bonds. 

Alternatively, targeting a specific type of bond, like corporate bonds, can have certain benefits for your portfolio. Compared to other types of bonds, corporate bonds can result in higher long-term returns via their greater income potential. This guide will provide all you need to know about investing in corporate bonds. 

What Are Corporate Bonds?

When a company wants to raise money, it usually has two options: equity or debt financing. With the equity option, a company can issue additional shares. This approach can dilute shareholders and can be unpopular for that reason. When more shares are issued, the existing shareholders lose ownership of the company proportionate to the number of new shares issued

With the debt option, a company can issue corporate bonds. These are debt securities the company sells to investors. An investor who purchases a corporate bond essentially loans the company money, with promises of periodic interest payments in the form of a semi-annual coupon. When the corporate bond matures, the investor receives their principal investment back.

Unlike stocks, investors who buy corporate bonds do not receive any ownership stake in the company. They simply hold an IOU, which does not entitle them to vote on shareholder decisions. But corporate bondholders rank higher in the company's capital structure compared to common shareholders. If the company goes bankrupt, gets restructured or is otherwise liquidated, corporate bondholders have priority claim over assets ahead of shareholders 

Corporate bonds come in two broad categories: investment grade and noninvestment grade.  This distinction refers to their credit quality, which tells investors about the risk of the company defaulting on the debt. A corporate bond with a low credit quality is more likely to miss or be late with interest or principal payments than one with a high-quality rating. Bonds with lower credit ratings will usually pay higher interest rates to compensate for the risk. 

Where to Buy Bonds

What Do Corporate Bonds Pay For?

Companies can use the proceeds received from selling corporate bonds to finance a variety of projects. These capital expenditures are usually intended to grow the company in the future. Hopefully, the company can use these projects to generate revenue and cash flow to pay down the bond's interest and principal.

For example, a biotechnology company might issue a corporate bond to finance research and development into a new pharmaceutical product. A logistics company might issue a corporate bond to finance the construction of a new distribution center. A video game developer might issue a corporate bond to finance the development of a new title. 

Types of Corporate Bonds

Corporate bonds come in many different structures, which can affect their risk/return profile. The following types of corporate bonds are the most common:

Fixed Rate 

Fixed-rate corporate bonds are issued with a set coupon rate that does not change throughout their maturity. For example, a corporate bond issued with a 7% coupon will pay that interest rate annually until it matures — even if broad interest rates change. Fixed-rate bonds with longer maturities or lower credit ratings tend to pay higher coupon rates. 

Floating Rate 

Floating-rate corporate bonds pay a coupon rate based on a difference (spread) over a benchmark interest rate or index. If the underlying benchmark increases, floating-rate corporate bonds will make higher interest payments. Conversely, if the underlying benchmark decreases, the interest payments of floating-rate corporate bonds will drop. Common benchmarks for floating-rate bonds include the Secured Overnight Funds Rate (SOFR) or the Fed Funds Rate (FFR). 

Zero Coupon 

Zero-coupon corporate bonds do not pay periodic interest payments. Rather, the corporate bond is issued as a discount relative to its face value. When the bond matures, the investor receives the face value of the bond. The difference between the initial price of the bond when sold at discount and its full redemption price represents the hypothetical interest received by the investor. 

Convertible

Convertible bonds are a type of hybrid security. Most of the time, they function like regular fixed-rate corporate bonds, with a set coupon rate, maturity date and face value. However, they also come with a conversion option. If exercised, the investor holding the convertible bond converts them into a set number of shares of the issuer's common stock at a certain price.

Why Invest in Corporate Bonds?

Higher yields: Corporate bonds generally pay higher coupon rates compared to Treasury or municipal bonds of similar maturity. This is to compensate for their higher degree of credit risk. The difference in yields between a government bond and a corporate bond with identical maturities and cash flows is known as the corporate bond spread. 

Historical long-term returns: From 2003 to the present with all coupons reinvested, corporate bonds as an asset class outperformed the benchmark U.S. 10-year Treasury bond, with higher overall returns and similar volatility. Corporate bonds also outperformed in terms of one- to 15-year rolling periods. 

Source: Portfolio Visualizer

Source: Portfolio Visualizer

Diversification: Corporate bonds possess positive expected returns, decent volatility and a low correlation with stocks, which make them a good candidate to diversify a portfolio with. From 2003 to the present, corporate bonds as an asset class posted a 0.37 correlation with the total U.S. stock market, which is sufficiently low to provide diversification benefits. 

Source: Portfolio Visualizer

Considerations Of Corporate Bonds

While corporate bonds have many benefits, they also carry some risks that could make them unsuitable for some investors. Some considerations with corporate bonds to watch out for include:

Credit rating: Corporate bonds can be separated based on their credit rating into investment- versus noninvestment-grade bonds. The former usually have a credit rating of at least BBB or Baa by Standard & Poors and Moody's, respectively. The latter are referred to as junk bonds or high-yield bonds and have credit ratings below BBB or Baa. 

Market risk: Corporate bonds can lose substantially in value during times of economic crisis or market crashes as the creditworthiness of their companies gets called into question. Case in point, corporate bonds incurred long bouts of losses during the 2008 Great Recession, the 2020 COVID-19 Crash and the 2022 bond bear market. 

Source: Portfolio Visualizer

Duration: Corporate bonds with longer maturities tend to have high durations, a measure of interest rate sensitivity. Because bond prices are inversely related with interest rate movements, an increase in rates can cause them to lose value proportional to their duration.

Callability: Some corporate bonds have a call provision. If this is the case, the issuer can recall the bond and pay it off early, which can be detrimental for investors relying on longer, consistent cash flows. Companies will usually call a bond when interest rates fall below the coupon rate of the bond, as they can essentially refinance the debt at a more favorable rate. 

Frequently Asked Questions