In simple terms, a corporate bond is an IOU, with several monikers including notes, bills and debt securities. In the case of corporate bonds, the issuer is the private company that needs the money. In return, the corporation agrees to pay the investor purchasing the bond not only the principal of the debt at some future date, but interest for the money loaned as well.
Bonds are known as fixed income because their rates are determined ahead of time. With a typical corporate bond, a predetermined pay-back date is set, typically one year from the date it was first issued. Shorter time spans fall under the rubric of "commercial paper."
Along with its annual shelf life comes a periodic interest rate payment. This makes corporate bonds a more predictable investment than stocks in some ways because dividends can shift (or disappear altogether) depending on the stock.
An investment advisor may develop a portfolio so that there is a mixture of investment types, including corporate bonds among them.
Why a Bond?
There are many different ways for an individual to grow his money, all associated with different levels of risk. One of the ways to invest that's considered to be less risky than common stocks is in a class known as corporate bonds.
To increase cash flow and provide financing for corporate investment, private companies issue bonds. Types of companies issuing bonds include those in the financial, industrial, and service sectors.
Bonds are also issued by the federal and state government bodies. When most people think of bonds, government bonds (or "gifts") are what they typically associate the concept of bond with. The corporate bond category is often expanded to include municipalities issuing debt, but typically a corporate bond can only be issued by a private company.
Why Invest in Corporate Bonds?
Like all investments, corporate bonds have risk. Unlike stocks, however, bonds are usually considered to be more stable investments with a lower risk associated with them. But research is crucial. Bonds are graded: the safest are called AAA, thus helping investors determine the level of risk they're comfortable with. Those bonds associated with the AAA to BB part of the scale are usually blue-chip firms and are known as "investment-grade" bonds. Bonds in the BB to D levels are known as "high-yield" bonds, or more commonly, "junk bonds."
In general, corporate bonds are considered to be riskier than those issued by the government. The trade-off comes with a higher rate of interest in corporate bonds.
Factors that Affect Investment in Bonds
Several elements should be considered in evaluating the risk any individual corporate bond presents. These factors include the price paid, the interest rate of the bond, the date the investment will be repaid (its maturity), and the yield (the value of the bond plus interest earned), which is usually quoted in basis points.
Other factors include the redemption (for example, some corporate bonds have a “call” feature allowing the corporation to redeem the bonds early at a specific price point), default history, credit ratings of the bonds and the taxable rate of interest from the bonds.
In the unlikely case of a company default, bonds are safer than stock purchases because a bond holder ranks higher in the line-up to be paid than shareholders.
There are some ways in which government bonds or gifts offer more benefits than corporate bonds. For example, US Treasury Bonds frequently are free of taxation by state and local bodies. Similarly, some municipal bonds do not tax citizens of the state who buy them in the state where they were issued. No such benefits accrue to corporate bond holders.
No Investment Choice is Simple
What all these factors point to is the notion that what at first appears to be a simple, relatively risk-free investment can turn out to be much more complicated investment choice than first thought. Learning to embrace investment tools like a bond index (such as the Dow Jones Corporate Bond Index) can help investors make informed investment decisions.
Like most investments, knowing the history of the company issuing the corporate bonds and understanding the factors that surround the sale of those bonds are key to making a wise investment choice.
The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. Comments concerning the past performance are not intended to be forward looking and should not be viewed as an indication of future results.
All investments involve varying levels and types of risks. These risks can be associated with the specific investment, or with the marketplace as a whole. Loss of principal is possible. Fixed income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications and other factors.