What Are Corporate Bonds?

Corporate bonds are a way for a company to raise money without issuing stock, or equity, and without borrowing from a bank. Corporate bonds can be a solid part of your portfolio, but it’s important to understand how they work. Here’s what you need to know.

What is a Corporate Bond?

A corporate bond is a debt obligation, meaning that the buyer provides money to the corporation in exchange for their promise to pay it back at a later time, with interest. Bonds usually pay interest twice a year, and then the principal is due when the bond matures.

Three Terms to Know About Bonds

A corporate bond has three important components: the par, or face, value; the interest rate; and the maturity date. Here’s why each of these things is important.

The par value, or face value, of the bond is the price the corporation wants to get for the bond. Most corporate bonds have a par value of $1,000. If you wanted to invest $100,000 in corporate bonds, you would buy 100 bonds at par. Bonds may or may not sell at par — this is where the law of supply and demand comes in.

The interest rate, sometimes called the coupon rate, tells you how much interest you will earn on the bond. Interest on corporate bonds is usually paid twice per year, but the interest rate is expressed in annual terms. If you purchase a bond with a par value of $1,000 and a coupon rate of 10%, you will get $100 in interest each year, in two payments of $50 each.

The maturity date is the date the bond is due. Twenty years is a common maturity for a corporate bond, although most bonds can be “called,” or paid off, by the issuer prior to the maturity date. If your $1,000 bond paying 10% interest matures in 20 years, you would get $50 in interest every six months for 20 years, or a total of $2,000 in interest. At the end of 20 years, you’d also get back the $1,000 that you paid for the bond.

Zero-Coupon Bonds

Some bonds, called zero-coupon bonds, do not pay interest during the term of the bond. They are purchased for prices below par, then the par value is paid when the bond matures. The investor’s return is the difference between the purchase price paid for the bond and the par value.

For example, a five-year zero-coupon bond with a par value of $1,000 might sell for $750. When the bond matures in five years, the investor gets $1,000. The $250 difference represents the investor’s return on their investment.

Corporate Bond Prices

The par value of a corporate bond is not necessarily the selling price. Since the interest rate and the maturity date are set by the company, the price will vary based on supply and demand. A corporate bond issued by a large company with strong financials may sell above par, while a bond issued by a smaller or newer company, or one with a weaker financial position, may sell at a discount.

Regardless of the price you pay, when your bond matures, you’ll get the face value.

If you purchased a 20-year bond with a face value of $1,000 and a 10% coupon rate for $900, you’d earn an extra $100 over and above the $2,000 in interest, and the $1,000 at maturity. If you purchased a 20-year bond with a face value of $1,000 and a 10% coupon rate for $1,100, you’d still get the $2,000 in interest and the $1,000 at maturity, but your return would be less because you’d have paid an extra $100 to begin with.

So why wouldn’t you only buy corporate bonds at a discount? Bonds are typically less risky than stocks, but they still have risk. If the company issuing the bond goes bankrupt, you may not get back the money you paid for the bond. However, in a bankruptcy, bondholders are paid before stockholders.

In fact, bondholders are second in line to get paid, behind secured creditor. A secured creditor’s loan is backed by collateral, which is something of value the company puts up when taking out the loan. If the company defaults on the loan, the lender can sell the collateral to recoup their money.

What’s the Difference Between Corporate Bonds and Stocks?

Corporate bonds and stocks are similar in some ways, but opposite in others. As such, having both in your portfolio can be a good diversification strategy.

Bonds

A bond is a loan from you to the corporation. The corporation pays you interest during the term of the bond, and when the term is over, they also pay you back the money you loaned them. The amount of interest and the payoff amount are fixed — you know how much money you’re going to get and when.

The risk is that the company could go bankrupt and if it did, you may not get all your money back.

Stocks

When you buy stock, you are buying equity, a piece of the corporation. The value of the stock is dependent on what someone else will pay you for it if you want to sell. Presumably, if the corporation makes money and its prospects are good, the value of your investment will go up. But it could also go down.

You have no way of knowing for sure whether the value will go up or down over any given day, week or year. And if the corporation goes bankrupt, you may get nothing.

FAQ

• Are corporate bonds a good investment?

  • Corporate bonds can be a good investment if you're looking for a fixed rate of return over a certain period of time. They're often preferred by retirees because they tend to be less risky than stocks, but they may also provide lower returns over time.

• How does a corporate bond work?

  • A corporate bond is a loan from an investor to the corporation. An investor buys a bond, the corporation pays the investor interest over the life of the bond, and then at a certain point, the corporation pays the investor back the amount of the bond.

• What are five types of corporate bonds?

  • - There are investment-grade bonds, which are considered relatively low risk.

  • - There are non-investment-grade bonds, also called 'junk' bonds, which have a higher risk of default.

  • - Fixed-rate bonds pay a fixed rate of interest over the term of the bond.

  • - Floating-rate bonds have an interest rate that can vary over the term.

  • - Zero-coupon bonds do not pay periodic interest, but are sold at a discount to the face value. When the bond matures, the face value is paid to the investor.

• Are corporate bonds high risk?

  • Most corporate bonds are not high risk, because they pay a pre-determined amount of interest over a pre-determined period of time. There is some risk that the company may go bankrupt, so look for investment-grade bonds from companies that have been in business a long time and have solid financial results.

  • They're often preferred by retirees because they tend to be less risky than stocks, but they may also provide lower returns over time.

This article originally appeared on GOBankingRates.com: What Are Corporate Bonds?