We know it sounds crazy, but even corporations need more money sometimes. Well, need might be a bit of a stretch. Whether it’s a huge publicly traded company or a privately owned small business, organizations can issue corporate bonds as a way to build and grow their business.
In general, bonds, including corporate bonds, are considered less risky than stocks. But just because something seems like a safe bet doesn’t mean it’s right for you. When it comes to investing, there are a lot of things to consider. So let’s take a closer look at corporate bonds and see if they’re worthy of a spot in your retirement portfolio.
What Is a Corporate Bond?
A corporate bond is a type of bond issued by a private or public company to raise money for projects that will help them grow their business. Companies typically issue bonds when they need more money than a bank will loan. So who do they turn to? You! Every bond you purchase is like an IOU. Like with other types of bonds, you are the lender and the other party is the borrower.
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Corporate bonds are a type of fixed income investment. You might be familiar with other common fixed income investments like certificates of deposit (CDs) or money market funds. These are all types of investments that leave you with a steady stream of income, through interest or dividends, and are less risky than stock. Let’s see how they work.
How Do Corporate Bonds Work?
Companies issue corporate bonds for lots of reasons. A company might turn to the market—aka, you—to invest in them so they can fund:
- Mergers and acquisitions
- New projects
- The purchase of new equipment
- Research and development
- Buying back their own stock
- Dividends to shareholders
- Refinancing their debt1
Unlike buying stock, when you purchase corporate bonds, you don’t own equity in the company. You only earn interest on the principal (the money you initially loaned), no matter how well the company performs. This is what makes them “safer” than stocks. When you buy a bond, you know from the very beginning how much you’ll make in interest and when you can expect your principal back. There are a few exceptions to this, like in the case of variable interest rates or if a company goes bankrupt, but for the most part what you see is what you get!
Here’s a quick example of how corporate bonds work. Say Widgets, Inc. is interested in building a new type of widget. To do so, they’re going to need a surge of cash to pay for research and development. They decide to issue a round of corporate bonds. Each bond is $1,000, earns a 2.85% fixed coupon rate (fancy bond talk for interest rate), and matures (the date when you get your principal back) in five years. If the interest is paid annually, you’ll earn about $152 at the end of those five years. We don’t know about you, but $150 bucks doesn’t sound all that enticing.
Lower risk means lower reward. And you know what the average interest rate on corporate bonds these days is? Hold onto your hats! It’s a whopping 2.7–2.85%.2 At those rates, you’d almost be better off dropping your money in a high-yield savings account. Now, these rates fluctuate like anything else in the market, and there will be times those rates go higher . . . and lower.
How to Measure the Risk of Corporate Bonds
Different types of corporate bonds will mean different returns on investment. There are four main ways to evaluate corporate bond risk.
Corporate bonds mature at different rates. Most of the time, the shorter the time to maturity, the lower the interest rate. The shorter time period makes them less risky. Why? Think about your own life for a minute. If you had to predict what the next few months of your life will look like vs. the next 10 years, which prediction do you think would be more accurate? A lot can happen in a decade—to a company and the market—so corporate bonds with shorter maturity dates are more likely to go to plan.
Here’s how maturity is measured for corporate bonds:
- Short-term: Less than three years
- Medium-term: 4–10 years
- Long-term: More than 10 years
With a long-term maturity date, you’re likely to snag a higher interest rate, but again, it might come with a cost down the road.
Just like (some) people have credit scores, so do corporate bonds and the companies that issue those bonds. Credit agencies are looking at one thing when they’re evaluating corporate bonds: default risk. They want to know how likely a company is to not make good on their bond. Corporate bonds may be investment grade, meaning they’re more likely to be paid on time, or they may be non-investment grade, meaning they come with a higher interest rate but with a greater risk of default. Non-investment grade corporate bonds are also called high-yield or speculative bonds.
Generally speaking, people invest in corporate bonds because they’re a mostly low-risk place to park your money where you know how much interest you’ll earn before you begin. Remember that corporate bonds are a type of fixed-income investment? Well, when people are investing in corporate bonds, they’re usually earning a fixed interest rate—or coupon rate—on those bonds. That means the coupon rate and the interest payments—or coupon payments—stay the same for the life of the bond, no matter what the market does. See why that might be appealing for a lot of people?
But there’s also what’s called a floating rate. If a corporate bond has a floating rate, that means its interest rate is reset from time to time. That might be every six months, once a year or some other time frame based on market changes. So these types of corporate bonds definitely come with a higher risk, but you’ll almost always earn a higher rate of interest for it.
Zero-coupon corporate bonds are for very patient investors, and here’s why. The name says it all: zero-coupon, as in no interest payments. The way this type of corporate bond works is that you only receive the interest when the bond matures. These are basically discounted bonds. Let’s say you buy a bond for $750 and it matures in five years. At the end of the five years (with no interest payments until then), your bond is worth $1,000. That means you earned $250 in interest over those five years, but you had to wait a whole five years to get it!
We've been talking about what corporate bonds are and how they work, but how do you actually go out and get them? Let's break that down next.
How to Invest in Corporate Bonds
There are several ways to invest in bonds. You can buy new issues (these are called initial bond offerings), buy bonds on the secondary market (this is where bonds can be bought and sold again), or get bond mutual funds or bond exchange-traded funds (ETFs). Here’s how corporate bonds are generally bought and sold:
- Through a broker. A good broker who knows what they’re doing can help navigate the bond market.
- Directly with the U.S. government. Trusting the government to do much of anything for you feels like a giant eyeroll, but the U.S. government does have a program that will let you go through them and avoid a middleman’s fees.
- Through bond mutual funds and bond exchange-traded funds (ETFs). An investor can check out a mutual fund’s details or an ETF’s investment strategy and find the ones that fit their investment goals.
OK, so that’s all well and good, but what if the company that issues the corporate bonds goes bust, belly up, bankrupt. Then what?
Corporate Bonds and Bankruptcy
As low risk as corporate bonds can be, they’re not no-risk. Companies go bankrupt all the time. And when they do, they can leave behind a lot of collateral damage. One of the benefits of being a bondholder instead of a stockholder is that you have a claim on the company’s assets and cash flow before stockholders. The terms of your bond will determine your place “in line” to be paid.
If you own corporate secured bonds and the issuer of your bonds goes bankrupt, your investment is backed by things like property, equipment, securities portfolios or other assets that can stand in for the bond. Under Chapter 7 bankruptcy, the company liquidates (or sells off) its assets so it can pay back secured bondholders. Under Chapter 11 bankruptcy, the company still has another opportunity to get its business in order and return to making a profit. But if the company defaults on their bonds, then secured bondholders have legal right to foreclose on the company’s collateral in order to collect. This, unfortunately, will mean a trip to bankruptcy court.
Unsecured bonds, or debentures, don’t have any collateral attached to them like secured bonds. Instead of property, unsecured bonds may be tied to credit card debt, bank loans that aren’t backed by property and more. Bondholders have nothing but the “full faith and credit” that the company will make their interest payments on time (or at all). This type of bond typically comes with a higher return on investment because it’s a riskier product.
When a company goes kaput, it usually owes lots of people and entities money—employees, banks, customers, pensioners, suppliers, and on and on. After secured bondholders are paid, then come employees, then unsecured bondholders. Third in line is not a place you want to be!
When it comes to corporate bonds and bankruptcy, there’s no guarantee you’ll get your money back. No investment strategy is without risk, but some investments are smarter than others.
Are Corporate Bonds a Good Investment?
The short answer? No.
We could stop right there, but here’s the long answer: As mentioned, corporate bonds are generally a low-risk, low-reward investment. But when it comes to saving for retirement, time is money. You need to maximize every dollar you invest. And corporate bonds just aren’t going to cut it.
Now we're not saying is the solution is a high-risk, high-reward alternative. Nope, not saying that at all. What we teach is investing at least 15% of your income in a mix of growth stock mutual funds. (That is, once you’re debt-free and have a fully funded emergency fund in place.) When you invest in growth stock mutual funds, you’re looking at 10–12% returns on your investment. With corporate bonds, you’re going to be lucky to outpace inflation. And your goal with investing is to beat the market so you can build wealth.
Get With a SmartVestor Pro
If you’re skipping corporate bonds and ready to invest in growth stock mutual funds, we have one more suggestion. Get with a SmartVestor Pro. These folks have been vetted by our team here at Ramsey Solutions and they know what they’re doing. Whether you’re just starting to invest or looking to really put things into high gear, a SmartVestor Pro can help you create a plan.
This article provides general guidelines about investing topics. Your situation may be unique. If you have questions, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.