Corporate bonds

Introduction

Corporate bonds are debt securities issued by companies. Instead of raising money by selling additional ownership through stock, a company can borrow from investors and agree to repay that debt according to the bond’s terms.

Corporate bonds cover a wide spectrum of risk. Debt issued by a financially strong company can behave very differently from bonds issued by a highly leveraged or financially distressed business. Investors therefore need to look beyond the coupon rate and consider credit quality, maturity, market price, and other features.

Understanding corporate bonds also helps explain why some bonds offer higher yields than government securities and why those higher yields generally come with additional risk.

What are corporate bonds?

A corporate bond is a bond issued by a company to borrow money from investors. The company becomes the borrower, while bondholders become creditors.

The bond’s terms describe the amount borrowed, maturity date, interest payments, and other conditions. If the company meets its obligations, investors receive the payments promised under those terms. If the company runs into financial difficulty, bondholders may face delayed payments, restructuring, or losses.

Unlike common shareholders, corporate bondholders generally do not receive ownership or voting rights simply because they own the company’s debt.

Why companies issue bonds

Companies issue bonds for many of the same reasons they borrow from banks. Proceeds may be used to expand operations, purchase equipment, finance acquisitions, refinance existing debt, or fund other corporate activities.

Bond financing allows a company to raise capital without issuing new shares and diluting existing shareholders. However, debt creates contractual payment obligations and can increase financial risk if a company borrows more than it can comfortably service.

How corporate bonds generate returns

Many corporate bonds pay a fixed coupon and return their face value at maturity, assuming the issuer does not default. Investors can also buy and sell bonds in the secondary market, where prices fluctuate.

If a bond is purchased below face value, its return can include both coupon income and price appreciation toward the amount repaid at maturity. If purchased above face value, part of the coupon income may be offset by the difference between the purchase price and the maturity value.

This is why investors often focus on bond yield rather than the coupon rate alone.

Credit quality and bond ratings

Credit risk is a central consideration for corporate bond investors. It refers to the possibility that a company will be unable or unwilling to make required interest or principal payments.

Credit rating agencies assess issuers and individual debt securities using rating scales intended to indicate relative credit risk. Ratings can help investors compare bonds, but they are opinions rather than guarantees and can change as an issuer’s financial condition changes.

Corporate bonds are commonly grouped into investment-grade and below-investment-grade categories. Below-investment-grade bonds, often called high-yield bonds, generally need to offer higher yields to compensate investors for greater perceived credit risk.

Why corporate bond yields differ

Corporate bond yields are influenced by broader interest rates and by risks specific to the issuer and security. Investors generally demand more yield when they perceive a greater chance of loss or greater uncertainty.

Corporate bonds vs government bonds

For more detail on public-sector debt, see our guide to government bonds.

What happens if a company defaults?

A default occurs when an issuer fails to meet obligations under its debt agreement. The outcome for bondholders depends on the circumstances, the bond’s legal position, available assets, and any restructuring or bankruptcy process.

Bondholders generally rank ahead of common shareholders in claims on a company’s assets, but that does not guarantee full repayment. Different bonds from the same company can also have different levels of seniority or security.

Because recovery can be uncertain, investors should consider both the probability of default and the potential loss if default occurs.

Risks of corporate bonds

Corporate bonds combine several forms of risk. Credit deterioration can reduce a bond’s price, rising interest rates can hurt existing fixed-rate bonds, and limited liquidity can make a position harder to sell. Callable bonds can also be repaid early under specified conditions, potentially forcing investors to reinvest at less attractive rates.

Inflation can reduce the real value of fixed payments as well. These risks are discussed in more detail in our guide to bond risks.

Key takeaways

• Corporate bonds allow companies to borrow money from investors without selling ownership.
• Bondholders are creditors and generally rank ahead of common shareholders in a bankruptcy, although repayment is not guaranteed.
• Corporate bond yields reflect market interest rates as well as credit, liquidity, maturity, and bond-specific risks.
• Credit ratings provide opinions about relative credit risk but do not guarantee repayment.
• Below-investment-grade bonds generally offer higher yields because investors face greater perceived credit risk.
• Investors should evaluate both the issuer and the specific terms of a corporate bond.