How to Invest in Corporate Bonds

When you invest in a bond, you’re essentially loaning money to the issuer—a company, government, or another entity. In return, the issuer promises to pay back the face value of the bond along with an additional interest rate by a specific deadline. In a way, bonds are similar to IOUs, with the issuer acting as the borrower and the investor as the lender.

There are several types of bonds you can invest in, ranging from U.S. government securities and municipal bonds to mortgage-backed, asset-backed, and corporate bonds. Corporate bonds—particularly those with high ratings and various maturity periods—are valuable for investors seeking to build a well-rounded portfolio. These bonds can help you accumulate savings for retirement, fund your children’s college education, or create a cash reserve for unexpected expenses, vacations, or other future financial needs. But how exactly do you go about investing in corporate bonds? Let’s break it down step by step.

Key Takeaways

• Corporate bonds are issued by businesses looking to raise additional funds.
• You can purchase these bonds through the primary market via a brokerage firm, bank, or bond trader.
• Some corporate bonds are traded on the over-the-counter (OTC) market, offering good liquidity.
• Before diving in, it’s essential to understand the fundamentals of corporate bonds, including how they’re priced, what risks are involved, and the interest they pay.

What Is a Corporate Bond?

Corporate bonds are debt securities companies issue as an alternative means of raising funds without diluting ownership through new stock issues or borrowing from traditional lenders like banks. When companies issue bonds, they promise to repay the bond’s face value (or principal) by a specified maturity date and make periodic interest payments.

Corporate bonds can be publicly traded or privately held. The funds raised from bond sales may be used for various purposes, including purchasing new assets, funding research and development (R&D), refinancing existing debt, financing mergers and acquisitions (M&A), or even conducting stock buybacks.

Instead of purchasing individual corporate bonds, investors may choose to invest in a bond fund or an index-pegged fund, which is passively managed and linked to the average performance of a collection of bonds.

Buying and Selling Bonds

Purchasing corporate bonds is as straightforward as investing in stocks. Bonds can be bought on the primary market through brokers, banks, or bond traders who facilitate the sale for a commission. The price of a bond is expressed as a percentage of its face value. For instance, if a bond is priced at 95, it can be bought for 95% of its face value. So, if the face value is $10,000, the investor will pay $9,500 for the bond.

Corporate bonds also trade on the over-the-counter (OTC) market, which offers liquidity—meaning investors can quickly sell the bond for cash when needed. The face values of these bonds usually start at $5,000, allowing investors some flexibility in the amount they wish to invest.

Critical Characteristics of Corporate Bonds

Corporate bonds can be lucrative and reliable sources of income, but understanding their key features—such as ratings, risks, pricing, and interest payments—is crucial for making informed investment decisions.

Ratings and Risk

Credit rating agencies like Standard & Poor’s (S&P), Moody’s, and Fitch assess a corporate bond’s risk level. To assign a bond rating, these agencies evaluate various factors, such as the company’s financial health, current debt levels, and future growth potential. This rating reflects the issuer’s ability to repay the bond.

• Bonds rated AAA (Aaa) to BBB (Baa) are considered investment grade, meaning they are less likely to default and relatively safe for investors.
• Bonds with a BB (Ba) rating or lower, known as junk bonds, are riskier but offer higher yields. Companies often issue these bonds with liquidity issues or other financial difficulties.
• Corporate bondholders have a claim on the company’s assets in bankruptcy, which could provide some protection against a total loss of investment.

Bond Prices and Interest Payments

Bond prices fluctuate based on market conditions and are usually listed in financial publications such as The Wall Street Journal or Barron’s. Suppose you observe a decline in bond prices. In that case, it typically means that interest rates are rising because the bond is cheaper to buy, while its original interest rate remains the same. Conversely, the effective yield (interest paid) decreases when bond prices increase.

Bonds with longer maturity dates generally offer higher interest rates to compensate for the increased uncertainty and risk associated with the issuer’s long-term financial health. For example, a bond issued today might face unforeseen financial difficulties years later, making it riskier for investors.

Some bonds, known as callable bonds, allow the issuer to repay the principal before the bond’s maturity date. While this option can benefit the company, it could mean a loss of future interest payments for investors. However, the company usually pays investors a premium if the bond is called early.

Bond interest is typically paid every six months. Bonds with lower risk usually have lower returns, whereas riskier bonds offer higher interest rates to attract more investors. Although high-risk bonds can be a lucrative source of income, it’s essential to remember that they carry a greater likelihood of default.

The Bottom Line

A balanced investment portfolio should include a mix of corporate bonds with varying maturity dates to ensure a steady income stream. While no corporate bond is entirely risk-free, those with higher ratings are more reliable and can help generate consistent returns over time. By understanding the key characteristics of corporate bonds—such as their ratings, pricing, and interest payments—you can make more informed investment decisions that align with your financial goals.

Investors should also remember that no investment is risk-free. It’s always wise to consult a qualified financial advisor to assess your circumstances and develop a suitable investment strategy.