What Is a Corporate Bond?
A corporate bond is a bond issued by a corporation. In other words, it is a piece of paper (or in today’s world, a bit of data on a computer) that says you lent money to some company, for a certain amount of time, and that in return, the company will pay you a set amount of interest. In some cases the interest is paid periodically throughout the life of the bond; in others, bondholders receive a lump-sum when the bond matures and the loan is repaid.
What Are the Risks of Investing in Corporate Bonds?
All investments have risks. The trick is to know the risks you are facing and to determine if they are worth it. There are two main risks with corporate bonds:
Credit Risk: It is always possible that the corporation will not have enough money to repay the loan. The more established the company and the more secure its finances, the lower the chance of that happening. When bonds are issued, they are given a credit rating between AAA and D. The higher the rating, the lower the interest rate, and the lower the possibility of default.
Interest Rate Risk: You can find corporate bonds with terms from three months to thirty years. Over time, interest rates can change a lot. If you own a bond that pays 3% interest and next year I can buy a similarly-rated bond that pays 4% interest, if you want to sell yours to me, you are going to have to lower the price. In the same way, if interest rates fall, and a year from now you want to sell your 3% bond, I’ll be willing to pay more than face value for it, since the interest rate is so good.
All that being said, however, as long as you don’t sell the bond, its price is not going to matter to you. Assuming no default, the interest rate you were promised when you bought the bond will be paid on schedule and, at the end of the term, your full principal will be returned.
How Do You Buy Corporate Bonds?
All the major investment houses sell individual corporate bonds and you can either pick your own via their website or consult with an advisor who will help you with your selection. As with most things in life, doing it yourself saves money. However, if you do not understand what you are purchasing, the help of an advisor could keep you from making a very expensive mistake.
The other way to invest in corporate bonds is via a mutual fund or ETF. These funds are offered by all the major fund families and brokerage houses. They may try to cover the entire bond market or just focus on one aspect of it. Just like the price of individual bonds may fluctuate based on interest rate changes, the price of the shares of bond funds may fluctuate with interest rates. However, while individual bonds (other than those that default) are guaranteed to pay you the agreed-upon principal and interest at the end of the term, owners of shares in a bond fund may receive less than they paid for their shares.
Why Should I Invest in Corporate Bonds?
Bonds add stability and income to a portfolio. While changes in interest rates may cause changes in the price of bonds or bond fund shares, those changes are usually relatively small, especially when compared to the changes in the stock market.
When your stock portfolio drops 20% over the course of a year, you’ll be glad you had some of your assets in bonds. While their long term returns are far less than that of stock, they hold their price and pay interest that can either be used to meet current needs or re-invested. Needing to sell stock during a market downturn in order to meet current needs could decimate your portfolio. Having a reserve of bonds than can be liquidated in that circumstance could be the difference between a comfortable retirement and penny-pinching.