Corporate bonds and how they work

Why are corporate bonds used? 

There are multiple reasons why corporate bonds make sense from an investor’s perspective. Firstly, they usually provide solid regular income from interest payments or fund dividends (more on those later). Secondly, the yield on corporate bonds is often significantly higher than for government bonds. On the flip side, greater yields often come with greater risk attached, particularly if the rating of your chosen corporate bond is on the low side. 

It's also possible to use corporate bonds as a means of speculating on a country’s interest rate. For example, if you believe the Federal Reserve is likely to hike the base rate, you may choose to avoid investing in bonds once rates move above the coupon rate of a bond. Similarly, if you feel the Federal Reserve was to slash the base rate soon, it could be an opportune moment to find corporate bonds that are higher than the potential future interest rate, offering a better overall return. 

If you decide to invest in a corporate bond and a few years down the line you want to get out, this is doable. The corporate bonds market has a highly liquid secondary market, where you can sell off your initial investment before maturity.

Understanding the quality of corporate bonds 

Before you jump to invest in corporate bonds, it’s important to educate yourself about the quality and risk of available bonds. Credit rating agencies will grade new corporate bonds issued by publicly listed companies, based on their fiscal fundamentals. If a company has a strong balance sheet and minimal debt, they are more likely to achieve a higher rating than a firm with dwindling cash flow and rising debt. 

A company’s corporate bonds are graded from A to D – A being the best available corporate bonds and D being the riskiest. These ratings are usually provided by three of the biggest credit rating firms– S&P, Moody’s, and Fitch. Each firm has its own metrics for determining corporate bond ratings but they usually arrive at similar grades. 

A-rated corporate bonds 

‘A’ credit ratings are the highest possible grading for a corporate bond. Any bond with this grading should give you confidence in the future of the business. Credit rating agencies only issue A ratings to bonds if they are certain a company has the lowest risk of default. 

Generally, A-rated corporate bonds have no issues with securing external investment. However, the interest rate offered is often lower than B, C, and D-rated bonds due to their lower perceived risk. The rule of thumb with corporate bonds is that the lower the risk, the lower the rate of return.

B-rated corporate bonds

A B-rated corporate bond is usually a sign that the issuing company is deemed a moderate credit risk. Any bond given a B rating by S&P, Fitch and Moody’s is usually considered “investment-grade”, making it a worthy option for investors. Yields on a B-rated corporate bond are often a little better than A-rated corporate bonds. 

C-rated corporate bonds

C-rated corporate bonds are the first to be considered what’s known in the industry as “junk bonds”. There are high levels of credit risk attached to these bonds. This is likely due to a company’s poor cash flow or credit history, making them more susceptible to defaulting on investor interest payments or going into bankruptcy and not being able to return your initial investment. 

When it comes to junk bonds in the ‘C’ category or lower, your appetite for risk needs to be considerably higher than usual. Bear in mind that a company’s financial situation can improve or decrease further still. If its rating is upgraded in the future, your bond may be more valuable to sell on in the secondary market. If it is downgraded to ‘D’, it may be almost impossible to sell it on in the secondary market. 

D-rated corporate bonds 

Factors influencing the price of corporate bonds

There are multiple reasons why corporate bond values can fluctuate when traded in secondary markets. The appeal of certain corporate bonds can increase or decrease based on one or several of the following factors: 

Interest rates

The base rate of interest has a major bearing on the value of corporate bonds. They can also influence the supply and demand of corporate bonds. If the base rate of interest defined by the national bank is lower than a bond’s coupon rate, the bond offers a better rate of return than a savings account, with demand likely to rise as a result. 

However, if interest rates move above the bond’s coupon rate, demand will likely wane as investors seek better, more reliable returns elsewhere. Additionally, when interest rates are higher, companies themselves are more reluctant to issue bonds as the necessary yields to drive demand could prove too expensive. 

Credit rating

Although investing in corporate bonds is said to be one of the safer investment decisions, the reality is that companies can still default unexpectedly. We’ve already explained the A-D credit rating of companies, but it’s important to reinforce the dangers of investing in ‘C’ and ‘D’ rated corporate bonds. These bonds may be considerably cheaper than ‘A’ and ‘B’ rated corporate bonds, but conservative investors should always take the lower risk and a more likely return on investment. Supply and demand 

Corporate bonds are no different to many other securities in that their values are largely driven by market forces of supply and demand. Demand is influenced by the appeal of a bond, in relation to the attractiveness of other investment opportunities in the markets. 

Supply is influenced by a company’s commercial targets, as well as the cost of borrowing through other avenues. If a company has a major project that needs finance to get off the ground, issuing corporate bonds could be a way to turbocharge the first stage of the process. So long as interest rates aren’t too high, companies should consider bonds as a credible means of funding big-ticket schemes. 

Rampant inflation 

Corporate bonds are not immune from the impact of high inflation. Rampant inflation can force the value of corporate bonds to plummet. The reasoning behind this is two-fold. A bond's coupon rate is less appealing when inflation diminishes the return’s purchasing power. Let’s say that the yield on a corporate bond was 5%, but inflation was running at 7%. In real terms, you would be losing 2% on your investment. 

In addition, higher inflation usually results in higher interest rates to combat inflationary environments. This too can force bond prices and market demand down. 

Proximity to maturity 

The price of a corporate bond is also intrinsically linked to its maturity. The closer it gets to maturity, the more likely it is to be worth close to the original sum invested. Newer bonds are more likely to take current interest rates into consideration. The price of longer-term bonds will fluctuate considerably through their lifespans, as economic conditions improve or worsen over time. 

The pros and cons of corporate bonds 

To help you fully understand the benefits and dangers attached to corporate bond investing and decide if it’s right for you, we’ve put together an extensive bulleted list of pros and cons. 

Advantages of investing in a corporate bond 

Investment-grade corporate bonds usually beat government bond returns

It’s true that corporate bonds with credit ratings of ‘A’ and ‘B’ usually outperform government bonds when it comes to yields. These so-called “investment-grade” bonds have historically been offered at 2%-3% higher than bonds issued by the US Treasury, for example. 

Debt instruments like corporate bonds can balance equity-heavy portfolios 

Diversification is everything when it comes to a balanced investment portfolio. Corporate bonds can act as a hedge against investments in equities, as they typically move in the opposite direction to stocks. 

Opportunities to profit on bond prices when the markets are volatile

Although corporate bonds are marketed as an income investment, speculation is still a viable option on corporate bonds too. With the fluctuation of bond prices based on interest rates and market volatility, there are opportunities to profit simply from buying and selling bonds via the secondary market. 

Regular interest income 

For those seeking a steady return on investment, corporate bonds are viewed as one of the safest options, especially those A- and B-rated instruments. 

Risks involved with corporate bond investing 

Fluctuating exchange rates 

Prospective hikes in interest rates can result in a decline in market value of bonds. Similarly, heightened inflation can erode the value of interest payments.  

Issuing company repaying the bond’s principal prior to maturity 

It’s entirely possible that your bond is repaid to you prior to maturity. If a corporate bond has a ‘call’ provision inbuilt, it means the business has the right to repurchase the bond and return the original investment at face value. This means you might not be guaranteed the interest payments through to maturity. 

It may not be easy to sell off your bond holdings 

The bond market is notorious for its lack of pricing transparency. Unlike the stock markets, it’s not easy to determine the appetite for buying bonds for those considering selling them on the secondary market. Liquidity can be an issue, although investment-grade corporate bonds are typically in high demand.   

Credit risks can change over the lifetime of a corporate bond 

There are no guarantees that a company won’t default on their corporate bonds. Even those deemed investment-grade may still experience financial difficulties and, worse still, bankruptcy. Fortunately, bondholders are deemed as creditors and often paid first during bankruptcy – even before shareholders. 

How to buy corporate bonds 

Individual corporate bonds 

Retail investors may consider buying individual corporate bonds issued by specific companies. Typically, these bonds are issued in blocks of USD 1,000 at a time. They can be acquired via financial brokers and investment platforms. Most brokers will charge a commission on bonds purchased online. 

At Saxo Bank, we charge just 0.20% for our Classic clients, across all US and European government bonds, as well as European and US corporate bonds. Platinum and VIP clients are charged just 0.10% and 0.05% commission respectively. 

Corporate bond funds 

An alternative investment route is to buy into a corporate bond fund. There are some mutual funds and exchange-traded funds (ETFs) that offer exposure to multiple corporate bonds, allowing you to spread your risk across a host of sectors. Corporate bond funds also offer a lower barrier to entry, which can be a great starting point for those new to investing in bonds.