One way companies borrow money is by issuing bonds. When you buy a corporate bond you're loaning money to the company. In return, you receive periodic interest payments until the bond matures and your principal investment is returned.
RiskCorporate bonds run the gamut when it comes to risk. Top-notch companies with pristine credit earned through strong balance sheets and long histories of repaying debt in a timely fashion issue bonds, as do struggling companies that might become insolvent in the near future.
As an investor, you'll earn a higher yield if you take on more risk, but you may deeply regret it later if you chose the wrong bond. You do, however, have some protection. Bondholders are higher up the ladder than people who own common stock of the same corporation. If the company goes bankrupt, bondholders are paid ahead of stockholders.
Two debt-rating agencies, Standard & Poor's and Moody's, assign credit ratings to corporate bonds based on the company's ability to repay its debts. These companies came under attack during the 2007 to 2009 recession for doing an inadequate job assessing, among other things, corporate debt instruments. Be prepared to do a fair amount of homework on your own -- or ask a professional -- before buying corporate bonds.
Buying a bondBonds are usually issued at a par value of $1,000. That is the amount you will receive if you hold the bond until maturity. If you buy 10 bonds at par you would pay $10,000. The stated interest rate issued with the bond is called the coupon.
Corporate bonds are routinely sold before maturity. Those bonds are then available on what's called the secondary market. On the secondary market you'll find bonds offered at a premium or at a discount to par, depending on market sentiment toward the bond at that time.
Once a bond is past the initial offering stage, its price and yield fluctuate with market forces. Keep in mind that yield and price are a seesaw in the bond world. When interest rates rise, the price of the bond falls; when rates fall, the price of the bond rises. If the price of a bond falls below par the bond is available at a discount. If the price rises above par, it's being offered at a premium.
While the coupon tells you the interest rate at the time the bond was issued, you'll need to look for the yield-to-maturity when buying on the secondary market. That is the yield you'll get when taking into account the premium or discount.
Grading bondsTwo major categories of bonds are investment grade and high yield, which is often called "junk." Investment grade usually implies lower risk of default and, therefore, lower risk to the investor. High-yield carries more credit risk and more risk to the investor, but that doesn't mean you shouldn't consider these bonds. If you have the ability to tolerate risk -- and you know what you're doing -- you can find some lucrative opportunities.
Within both categories you'll find bonds with various levels of risk.
Moody's and S&P assign a variety of ratings grades to investment grade and high yield bonds. The highest quality bonds are rated Aaa at Moody's and AAA at S&P. The lowest investment grade rating is Baa at Moody's and BBB at S&P. Venture into the high yield landscape and you'll find ratings ranging from Ba to C at Moody's and BB to D at S&P.
Alternatives to individual bondsExchange-traded funds and mutual funds offer investors a way to diversify bond holdings at fairly low cost. Corporate bond funds come in a variety of flavors -- short-, medium-, and long-term, investment grade, and high yield. They act much in the same way as individual bonds in that the net asset value, or NAV -- the price you pay per share -- rises as the fund's yield falls and vice versa.
It's important to know the average maturity of a bond fund. The longer the maturity, the higher the risk to the investor. If you want lower interest rate risk and credit risk, a short-term, investment grade bond fund may provide your best option when it comes to corporates.
Keep in mind that because there is no maturity date for the fund, just the underlying bonds, you can lose money if you sell your shares at the wrong time.
ETFs will generally mimic a corporate bond index, while mutual funds will also provide actively managed funds.