Corporate Bonds | How to Analyze, Compare, and Buy Corporate Bonds

Corporate bonds are issued by large companies as means to raise capital. It is a form of investment in which bondholders loan money to a corporation. The corporation then commits to paying interest on the loan until the maturity of the bond during which time the company pays back your original investment in full.

In this guide, we will be breaking the bonds topic in detail and telling you everything you need to know about corporate bonds. From how they work, expected earnings from bond investments, and their risk levels to where to buy them.

What are Corporate Bonds?

Simply put, a corporate bond is a form of debt security issued by an established company that’s looking to raise capital. The money raised may be used to fund any of the company’s projects like business expansion or operational costs. By purchasing the bonds floated by a given company, you are effectively loaning that company cash for a particular period of time and expecting it to pay interests for the utilization of such a loan.

A bond can be either fixed rate, implying that they pay a fixed interest rate on your loan for the duration of the loan or variable-rate bonds. They also will only be valid for a predetermined number of years – often more than 1 year – after which they expire/mature. At such a time, the interest payments cease and the bondholder is refunded their original investment – the principal.

They share some attributes with other forms of corporate securities like shares and stocks in that they both involve buying into the company. They both can be sold in secondary markets, that is the stock markets for shares and stocks and the bond markets for corporate bonds. The latter however stands out due to the fact that they have an expiry date. Plus, in the case a company dissolution, bondholders are paid before stockholders.

Corporate bonds are passive income generators. Compared to similar investments, bonds are considered safer/ less volatile than shares and stocks and though they are considered riskier that the government backed treasury bonds (T-Bonds), they pay a higher interest rate.

What are the pros and cons of investing in corporate bonds?

How do Corporate Bonds Work?

We have already mentioned that by investing in a corporate bond, you are essentially advancing the company a loan. The company on the other hand promises to pay a fixed or slightly variable interest for the use of the loan, often referred to as the bond yield. Corporate bonds have an expiry date, also known as the Bond maturity, at which point the borrowers refunds the principal amount you used to buy the bonds.

Lets breakdown these commonly used bond terms to better understand how corporate bonds work.

Corporate Bond Yields

One of the first things that you need to look out for when considering a corporate bond investment is the bond yield. In its most basic form, the yield refers to the amount of money you make on your investment per year – the return on investment. This is no different from the yield when investing in stocks and shares, or even keeping money in a savings account.

The yield is always expressed as a percentage of your original investment. In the case of corporate bonds, the yield dictates what your annual interest payments will be. For example, if you invest $10,000 into corporate bonds and the yield pays 5%, then you will make $500 in interest per year until the bonds mature.

As is the case with any other investment product, the higher the yield, the higher the risk. Interestingly, the yield on corporate bonds is actually determined by the company issuing them. The corporation will usually discuss this with the financial institution that has been tasked with bringing the bonds to market, to ensure that the yield reflects the underlying risks. If it doesn’t, then the company will have little success in selling its bonds, as investors are ultimately looking for value.

Corporate Bond Maturity

Bond maturity refers to the amount of time you allow the company to make use of your funds. Think of a bank loan like a mortgage. The number of years within which you must repay borrowed funds can be viewed as the maturity of the loan. Similarly, bond maturity refers to the number of years after which a company may use your invested funds. These can range from 1 to 10 or even 20 years depending on the company. Upon maturity, the company is expected to repay your invested bond funds in full.

In most cases, the longer the bond maturity term, the higher the chances of the company going under or defaulting on the bond and thus the higher the interest rates. You will do well to remember  that while bond interest rates can be variable, the bond term is fixed and cannot be adjusted upwards or downwards. Should you wish to recover the bond funds before its maturity date, you have the only option of selling it in the secondary bond markets.

Corporate Bond Coupon Payments

Its easy to confuse coupon rate payments for the corporate bond yields, primarily because they both allude to the returns realized from investing in corporate bonds. However, while the bond yield rate refers to its return on investment, the coupon rate refers to the interest rate the bond pays annually. The coupon rate will in most cases be expressed as a percentage of the face value of the bond. Differences in the coupon and yield rate often arise if the government increases the base lending rates or if the bondholder sells it at the secondary market at a rate higher or lower than its par value (the principle amount he invested in buying the bond.)

For example, a 6% yield on a $5,000 investment would pay $300 per year. However, the yield on a corporate bond investment can change once the bonds hit the secondary marketplace.

• Sticking with the same example as above, let’s say that Company ABC issued $50 million worth of bonds at a yield of 6%.
• 6 months after the issue, Company ABC reports worse-than-expected financial results
• This concerns investors, so bondholders are looking to offload their bonds on the secondary marketplace
• As the risks of the investment are now higher, bondholders must sell the bonds at a discount
• This means that new investors will get a higher yield, as they paid a lower price than the original bondholder

Although new investors will get a higher yield because they paid a discount through the secondary market, the ‘coupon payment’ does not change. The coupon payment refers to the fixed rate of interest that originally came with the bonds.

In this example, Company ABC issued the bonds at 6% per year, so bondholders will still receive their annual interest payments at a rate of 6%. Regardless of how well the bond issuer is performing, the coupon payment on the corporate bonds will never change.

How Much can you make from a Corporate Bonds investment?

How much money you make from a corporate bond investment varies from one company to another and is also dependent on a host of factors. For example, if the company issuing the bonds is deemed to be raising capital because it is having issues with cash flow, then you should expect the yield to reflect the increased risk. The high risk is reflected in relatively high interest rates.

If, on the other hand, the company has a strong balance sheet and is merely issuing the bonds as a means to invest in a new profitable venture or expand operations, then the yield will be low. And this is explained by the reduced default risk.

How much you make from corporate bond investments will also be determined by term of the bond. For example, the yield on a term of 25 years is deemed riskier and will therefore pay higher interest rates than a corporate bonds with a maturity of just 3 years.

Best performing corporate bonds in 2020

Are Corporate Bonds Risky?

As is the case with any investment prospect, you must have a firm understanding of the underlying risks. In the case of corporate bonds, the risks center on coupon payment default, principal payment default, and a reduction of yield in the open marketplace.

Let’s explore how each risk could impact your corporate bond investment.

Risk of Coupon Payment Default

When you borrow money from a bank, you are expected to make your monthly repayments on time. This is the risk that the bank takes in loaning the money to you, as there is always the chance that you miss a payment. Its no different when it comes to corporate bonds as there is always the possibility that the company may fail to settle its coupon payments on time. While its rare in the US to find corporates defaulting on the disbursement of interest, it could happen nonetheless. If it does, the coupon payment is carried forward and will be paid during the next month, quarter, or income call.

Risk of Principal Payment Default

An even greater risk to consider when investing in corporate bonds is a default on your principal payment. This is the money that you originally invested in the bonds, and it isn’t repaid until the bonds mature. For example, if you invest $15,000 into corporate bonds with a 10-year maturity, the company won’t be required to repay that $15,000 until the 10-year term concludes.

A default on the principal payment is much more likely than missing a coupon payment. This is because the issuing company will be required to pay out a considerable amount of money to all bondholders at the same time. For example,  let’s say that the company issued $60 million worth of corporate bonds at a term of 5 years and a yield of 4%.

This means that the company would need to honor $2.4 million worth of coupon payments every year. Although this might be manageable, the company would then need to distribute the full $60 million in 5 years’ time. There is no knowing what the state of the company’s balance sheet will look like in the future, so this is a major risk that you take when investing in corporate bonds.

Risk of Yield Decreasing

This particular risk is only applicable if you plan to sell your corporate bonds before they mature. If you don’t, then your coupon payments will always remain the same, meaning that you will get fixed interest payments until the bonds mature. However, as we covered earlier in our guide, the yields on corporate bonds will go up and down in the secondary markets.

The rise or fall of the running yield will be determined by market forces, so if a company is performing poorly, expect the yield to increase. If it does, this means that you will need to sell your bonds at a discount, as new investors will want to purchase the bonds at a higher yield than that of the fixed coupon rate.

How do I Buy Corporate Bonds?

Accessing corporate bonds is relatively hard  and a complicated process for the average investor. This is in stark contrast to US Treasury bonds, which you can buy online directly from the Treasury Office ane with an investment of just $100. The main barrier with corporate bonds is that companies typically issue them directly to financial institutions, as issuers prefer to sell the bonds in large quantities. This means that you will need to use a third-party broker that has access to the corporate bond markets.

Here are the primary ways of accessing the corporate bonds if you are a retail investor.

Option 1: Use a Third-Party Broker

If you want to buy and own the physical bond paper, you will need to use a brokerage firm

Step 1: Find an Online Broker That specializes in Corporate Bonds

Your first port of call will be to find an online broker that deals with corporate bonds. More specifically, you’ll need to ensure that the broker lists the corporate bonds that you wish to invest in, so you’ll need to do some digging at the provider’s website.

You will also want to look at other metrics when choosing an online bond broker, such as fees, eligibility, minimum investments, user-friendliness, and regulation.

Step 2: Open an Account and Verify Your identity

Once you’ve found a suitable broker, you will then need to open an account. You will likely need to enter the following personal information:

• Full Name
• Date of Birth
• Home Address
• Nationality
• Social Security Number
• Contact Details
• Annual Income
• Name and Address of Employer

You will then be asked to verify your identity. This usually requires an upload of your government-issued ID and a proof of address.

Step 3: Deposit Funds and Buy Bonds

Once you’ve verified your account, you will then need to make a deposit. Most bond brokers active in the online space allow you to deposit funds with a debit/credit card or bank transfer. If the size of your investment is large, then it will likely need to be the latter.

As soon as the deposit has been credited, you can purchase your chosen corporate bonds. Bonds come in pre-defined denominations – such as $100, $500, or $1,000. As such, you can’t buy a fraction of a bond.

Step 4: Receive Coupon Payments

Once the bonds have been purchased, you will then be entitled to coupon payments. This is usually paid every 6 or 12 months. The payments will usually be paid into your brokerage account, so you can choose to withdraw them out or reinvest them. At the end of the term, the full principal amount will then be paid back to you.

Option 2: Invest in a Corporate Bond Mutual Fund

The second option that you have at your disposal is to invest in a corporate bond mutual fund. This is where you invest money with a large-scale institution, who will buy and sell bonds on your behalf. Your money will be pooled together with thousands of other investors, so mutual funds typically have a multi-billion dollar war chest.

Key points to consider when using a mutual fund to invest in corporate bonds are:

• You will have no say in what corporate bonds the mutual fund invests in
• The mutual fund will consist of thousands of individual corporate bonds with varying risk-levels and maturity dates
• The mutual fund will often sell the bonds before they mature. It will strive to do this at a premium, but this won’t always be the case.
• You will receive a monthly payment from the mutual fund, which is linked to any coupon payments it receives on your behalf. This will always be at a different yield as it all depends on what bonds it is currently holding.
• You will also receive an annual payment from the mutual fund. This will represent profits made from selling the bonds before they mature.

If you like the sound of investing in a corporate bond mutual fund, follow the quickfire step-by-step guidelines listed below.

• Step 1: Find a Mutual Fund That Invests in Corporate Bonds
• Step 2: Open an Account and Verify Your Identity
• Step 3: Decide how Much you Wish to Invest and Then Deposit the Funds
• Step 4: Receive Varying Monthly Coupon Payments
• Step 5: Receive an Annual Capital Gains Payment

Can I Sell my Corporate Bonds Early?

Ideally, corporate bonds are specially designed as along term investment vehicles that earn you passive income until their maturity.  But what happens when you need to free up some cash by offloading the bonds early to solve an emergency or cushion your portfolio from significant losses? Enter the secondary bond market. Ideally most bonds can be used in the stock exchanges either individually or as a fund – mutual funds and ETFs. Put in mind that the corporate bonds secondary market isn’t as liquid as the market for shares and stocks or government securities like the  Treasury bonds.

As such, there is no guarantee that you will be able to offload your bonds before they mature.  More importantly, there is no guarantee you will be able to sell the bonds at their par value. The corporate bond secondary market is also dominated by financial institutions and this limits its access by a  retail investor. If you feel that you might need to sell the bonds early, make sure you use a broker that has direct access to the secondary bond market.

Conclusion

Corporate bonds give you the opportunity to earn passive income on a long-term basis. You’ll receive regular coupon payments until the bonds mature, and you get to choose the risk level that best meets your investment goals. Although corporate bonds market is harder to access , especially when compared to the US Treasuries for the average investor, there is no shortage of brokerage firms willing to hold your hand and help you invest in your preferred company.

You also have the option of investing in a corporate bond mutual fund, which comes with the added benefit of being able to withdraw your money out at any time. Ultimately, you are best advised to diversify your corporate bond portfolio as much as you can to mitigate the risks of a potential default.

Glossary of Bonds Terms

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