To finance capital investment and increase their cash flow, private corporations issue bonds. These companies can be in the service, financial, or industrial sectors. (Bonds are also issued by the federal and state governments, and when most people think of bonds, this is what they typically associate the concept of bond with.) While the corporate bond category is often expanded to include municipalities issuing debt, strictly speaking, a corporate bond can only be issued by a private company.
What Is a Bond?
In simple terms a bond is an IOU, with several monikers including “notes,” “bills,” and “debt securities.” In the case of corporate bonds, the “issuer” is the corporation, which needs money. In return, the corporation agrees to pay the investor purchasing the bond not only the principal of the debt but interest for the money loaned as well.
Associated with a typical corporate bond is a pay-back date, usually one year from the date it was first issued. Shorter time spans fall under the rubric of “commercial paper.” Along with the annual shelf life comes a twice yearly interest rate payment. This makes corporate bonds a more predictable investment than, for example, stocks. For that reason, an investment advisor will usually develop an investor’s portfolio so that there is a mix of investment types, bonds being one type.
Why Invest in Corporate Bonds?
Like all investments, corporate bonds are associated with risk. Unlike stock, however, bonds are usually considered to be more stable investments, and thus, usually lower risk. Corporate bonds, however, are considered to be riskier than bonds issued by the government. The trade-off, however, comes with a higher reward; in the case of corporate bonds, the reward is a higher interest rate.
Factors that Affect Investment in Bonds
Several factors need to be considered to understand the risk any individual corporate bond poses. These include the price paid for the bond, the interest rate associated with the bond, the date the bond will be repaid (its maturity), and the yield (the value of the bond plus interest earned) 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. For example, US Treasury Bonds are frequently not taxed by state and local bodies. Another example is that some municipal bonds do not tax citizens of the state who buy them in the state where they were issued.
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 use tools like a corporate bond index (such as the Dow Jones Corporate Bond Index) can assist in making an informed investment decision.
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.