Takeaways
- Corporate bonds are debt securities issued by companies to raise capital.
- Companies use bond issuance funds to pay for growth, product launches, etc.
- Moody’s, Fitch, and Standard & Poor’s are the three bond credit rating agencies.
- Corporate bonds are issued in increments of $1,000 and pay interest every six months.
- The highest bond credit rating is Triple A (AAA), and the lowest bond ratings are for high-yield or junk bonds.
What Are Corporate Bonds?
A corporate bond is a type of debt security issued by private and public corporations to raise money.[1] Companies issue bonds to pay for operational costs to keep them afloat, expand business operations, refinance existing debt, make acquisitions, and purchase equipment.
When a corporation issues bonds, it is a sort of crowdfunding effort. The company sells bonds to investors through the bond markets (analogous to a stock market). A corporate bond is an IOU to investors, and the company promises to pay investors back their principal investment plus regular interest payments. These interest payments are based on either a fixed or variable interest rate. Companies issue these interest payments, called coupon payments, to bondholders at regularly scheduled dates.
Corporate bonds are issued in increments of $1,000 face or par value and have maturity periods that range from months to decades. Bonds are considered fixed-income investments because they provide regular interest payments to the bondholders in fixed amounts. Institutional investors and passive income investors often use corporate bonds to build predictable income streams. They usually do this by creating a bond ladder.
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How Corporate Bonds Work
In the hierarchy of the 7 asset classes, corporate bonds are considered a relatively safe investment. Corporate bonds are considered riskier than U.S. Treasury bills (T-Bills) because the full faith and credit of the U.S. federal government does not back them. However, corporate bonds basically function the same way.
Corporate bonds are short and long-term loans that corporations take from investors. An investor who buys a corporate bond loans money to that company at a fixed interest rate in exchange for regular interest payments and the return of the initial amount loaned when the bond matures.
A bond’s interest rate or “coupon rate” is based on a basket of variables about the company issuing the bonds, including the company's credit rating, the prevailing interest rates in the market, and the maturity length.
Corporate bonds are issued in three different buckets of maturities. Here are the three tranches:
- Short Term: Less than 3 years
- Medium Term: 3 to 10 years
- Long Term: More than 10 years
All things being equal, longer-term bonds command higher interest rates because the investor assumes more timeline risk.
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The U.S. bond market is the largest securities market in the world, valued at over $51 Trillion.[2] Corporate bonds make up the largest component of that market.
Bondholders typically receive interest payments every six months, allowing investors to build a steady income stream. At the end of the bond’s term, the corporation repays the principal, the bond's face value. Investors can keep investing in bonds after their maturity to take advantage of compounding interest.
A corporation can default on its bond, which means it either fails to make interest payments or repay the principal. In either case, bondholders can face potential losses, which is the inherent risk of corporate bonds.
Corporate bonds are available in two types, either secured or unsecured:
- Secured bonds have the backing of specific assets owned by the corporation, acting essentially as collateral.
- Unsecured bonds, or debentures, are not backed by assets and rely solely on the issuers’ or owners’ creditworthiness.
Unsecured bonds usually pay a higher interest rate because investors take more risk lending to a company that is not backed by assets. The bonder doesn’t have any recourse if the company fails to make interest payments or return its principal. This is why the possible risk and return of different corporate bonds depend on not only the terms of the bond but also the financial stability of the issuer.
How Are Corporate Bonds Sold?
Corporate bonds are sold through a process known as underwriting, which investment banks manage. If a corporation decides to issue bonds, it works with an investment bank to determine the terms of the bond issuance, such as the issue price, maturity, and coupon rate. Then, the investment bank buys the entire bond issue from the corporation and resells the bonds to investors.
Corporate bonds are sold in primary or secondary markets. The primary market is where they are initially offered to investors, and the secondary market is where investors trade bonds among themselves. One notable benefit of the secondary market is that it provides substantial liquidity, allowing investors to buy and sell bonds freely at any time before maturation.
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How to Invest in Corporate Bonds
One of the best ways to add significant diversification and risk management to an investment portfolio is to invest in bonds. Corporate bonds can be a great way to add a steady, fixed income. This is why bonds are truly favored by investors nearing retirement, who are part of the FIRE movement, or who want to generate passive income.
If you want to invest in corporate bonds, you can purchase them directly through your online brokerage account. When buying bonds directly, you can choose from existing bonds on the secondary market or newly issued bonds in the primary.
Younger investors prefer corporate bond funds, which are exchange-traded funds or mutual funds that manage a diverse portfolio of corporate bonds. These funds are not only professionally managed but also diversified and highly liquid.
As part of researching what bond investment makes the most sense for you, assess the bonds' credit ratings. Higher-rated bonds have less risk and lower returns, but lower-rated bonds have higher risk and the potential for greater returns. If you are willing to accept the risk and want to juice your investment returns, try investing in high-yield corporate bonds.
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Corporate Bond Rating System
As part of the underwriting process, corporate bonds are rated by the three corporate credit rating agencies: Moody’s, Fitch, and Standard & Poor’s. [3][4][5]
Each rating agency gives investors a general assessment of the issuer’s creditworthiness and the corresponding risk of default. These assessments are forward-looking opinions about a business’s creditworthiness regarding the specific bond. Bond ratings act as a cheat sheet for investors on the stability and quality of bond issuance.
Bonds ratings also determine what interest rates bonds yield. Companies issuing investment-grade bonds will often have much greater financial stability and will pay a lower interest rate to investors than companies issuing junk bonds.
Credit bond ratings range from high-grade (low-risk bonds) to junk bonds (high-risk bonds). The highest credit quality is colloquially referred to as “investment grade” or “Triple A” (AAA) based on the three corporate credit rating agencies’ highest credit quality.
Why Do Companies Issue Bonds?
Corporations can issue bonds for just about anything for which they may need substantial extra cash. Companies often have bond issuances to raise capital for:
- Expanding current operations or taking on new projects
- Covering a financial shortfall
- Refinancing high-interest debt to improve long-term financials
- Acquiring new businesses or product lines
Companies sometimes prefer issuing debt capital, especially if they have the cash flow to cover interest payments. By issuing a bond instead of stock, companies don’t have to sell a piece of their business to raise money, and they can often issue bonds at a lower cost of capital than equity financing.
Smart Summary
C corporations need capital to grow their businesses. They can access the capital market via the equity capital markets by issuing stock (e.g., initial public offering) or the debt capital market by issuing bonds. If you want to generate a return on your money, investing in corporate bonds could provide you with regular interest income. Although bonds are considered less risky than assets like stocks or cryptocurrencies, financial advisors building well-diversified portfolios advocate that some bond exposure is essential.
Frequently Asked Questions
Most corporate bonds make interest payments every six months. However, some bonds pay interest monthly, quarterly, or annually. The rate of interest payments and maturity of the bond determines the bond’s price.
The Federal Deposit Insurance Corporation (FDIC) does not insure bonds, like high-yield savings accounts. This is essential in determining what investment is the best for your portfolio.
This depends on your risk appetite. Corporate bonds usually command higher interest payments but are considered riskier than T-Bills because the full faith of the U.S. government backs them.
(1) U.S. Securities and Exchange Commission. Bonds. Last Accessed January 14, 2025.
(2) World Economic Forum. Ranked: The largest bond markets in the world. Last Accessed January 14, 2025.
(3) Moody’s. Rating and Scaling. Last Accessed January 14, 2025.
(4) Fitch Ratings. Rating Definitions. Last Accessed January 14, 2025.
(5) Standard and Poor’s. S&P Global Rating Definitions. Last Accessed January 14, 2025.
