When investors buy a bond, they essentially lend money to the issuing entity. The bond is a promise to repay its face value—the amount loaned—with an additional specified interest rate within a specified period of time. The bond, therefore, may be called an IOU.

Bonds come in many different shapes and sizes. They include U.S. government securities, municipals, mortgage and asset-backed, foreign bonds, and corporate bonds. In a well-diversified investment portfolio, highly-rated corporate bonds with short-, mid-, and long-term maturity can help investors accumulate money for retirement, save for a college education for children, or to establish a cash reserve for emergencies, vacations, and other expenses. But how do you invest in this type of bond? Read on to find out the basics of investing in corporate bonds.

Key Takeaways

  • Corporate bonds are issued by companies that want to raise additional cash.
  • You can buy corporate bonds on the primary market through a brokerage firm, bank, bond trader, or a broker.
  • Some corporate bonds are traded on the over-the-counter market and offer good liquidity.
  • Before investing, learn some of the basics of corporate bonds including how they're priced, the risks associated with them, and how much interest they pay.

What Is a Corporate Bond?

Corporate bonds are issued by companies. Issuing bonds is another way for companies to access cash without diluting ownership through additional stock issues or by going to a traditional lender and taking out a loan. Bond issues can be either publicly traded or private.

Companies can use the money from bond sales for different reasons like buying new assets or facilities, investment in research and development (R&D), refinancing, funding mergers and acquisitions (M&A), or even funding stock buybacks.

As mentioned above, a corporate bond is just like an IOU. The company promises to pay the face value by a certain date plus interest at regular intervals during the year to the lender or investor who purchases the bond.

An alternative to investing in individual corporate bonds is to invest in a professionally managed bond fund or an index-pegged fund, which is a passive fund tied to the average price of a basket of bonds.

Buying and Selling Bonds

Buying bonds is just as easy as investing in the equity market. Primary market purchases may be made from brokerage firms, banks, bond traders, and brokers, all of which take a commission for facilitating the sale. Bond prices are quoted as a percentage of the face value of the bond, based on $100. For example, if a bond sells at 95, it means the bond may be purchased for 95% of its face value. A $10,000 bond, therefore, would cost the investor $9,500.

Some corporate bonds are traded on the over-the-counter (OTC) market and offer good liquidity—the ability to quickly and easily sell the bond for ready cash. This is important, especially if you plan on getting active with your bond portfolio. Investors may buy bonds from this market or buy the initial offering of the bond from the issuing company in the primary market. OTC bonds typically sell in face values of $5,000.

Key Characteristics of Bonds

Corporate bonds can be very reliable sources of income and can be very rewarding. But before you put your money down, it's important to know some of the basics about your investments—from how they're rated to pricing and interest rates.

Ratings and Risk

Bond ratings are calculated using many factors including financial stability, current debt, and growth potential. These ratings are assigned by the three major bond rating agencies Standard & Poor's, Moody's, and Fitch calculate the risk that comes with bond issues by assigning them a letter grade. These grades help investors and financial professionals understand whether the bond issuer can repay the debt or if it will default on its obligation.

Letter grades range from AAA or Aaa to BBB or Baa are considered investment grade. These bonds are considered safer and more stable investments because they are less likely to default. Bonds that come with a BB or Ba rating or below—including those that are not rated—are called junk bonds. These bonds have higher yields but carry a greater risk of default because they are issued by companies that have liquidity issues.

When a corporation goes bankrupt, bondholders have a claim against its cash and other assets.

Bond Prices and Interest Payments

Bond prices are listed in many newspapers and publications including Barron's, Investor's Business Daily, and The Wall Street Journal. The prices listed for bonds are for recent trades, usually for the previous day. But remember, prices fluctuate and market conditions may change quickly.

When bond prices decline, the interest rate increases. That's because the bond costs less, while the interest rate remains the same as its initial offering. Conversely, when the price of a bond goes up, the effective yield declines. Term bonds usually offer a higher interest rate because of their unpredictable performance. A company's financial stability and profitability may change over the long-term and not be the same as when it first issued its bonds. To offset this risk, bonds with longer maturity dates pay a higher interest.

A callable or redeemable bond is a bond that may be redeemed by the issuing company before the maturity date. Because these bonds can be called at an earlier date, you stand to lose the interest remaining in the life of the bond. The company, though, will pay you and other investors a cash premium.

So how do bond issuers pay interest? Interest on bonds is usually paid every six months. Bonds with the least risk pay lower rates of return. But those with the highest risk come with the biggest rewards. That's because they want to attract more lenders or buyers. Because they pay out interest regularly, bonds with the highest risk are generally considered a great source of income. But it's important to remember that, despite their potential, they are less reliable.

The Bottom Line

A well-diversified investment portfolio should hold a percentage of the total amount invested in highly-rated bonds of various maturities. Although no corporate bond is entirely risk-free and may sometimes even result at a loss because of changing market conditions, highly-rated corporate bonds could reasonably assure a steady income stream over the life of the bond.