Corporate bonds are a major source of capital for many businesses along with equity and bank loans/lines of credit. They can be quite secure or sometimes risky
Now that municipal bonds have been covered, let’s get to corporate bonds. Here you’ll learn about what corporate bonds are, how they work and how to buy them.
What are corporate bonds?
Corporate bonds are considered higher risk than government bonds. They’re a debt security issued by a corporation and sold to investors. The backing for the bond is usually the payment ability of the company. This typically means money to be earned from future operations.
The company's physical assets can sometimes be used as collateral for bonds. Because these bonds are higher risk, interest rates will be higher – even for top-flight credit quality companies.
How do corporate bonds work?
Corporate bonds are issued in blocks of $1,000 in par value, and almost all have a standard coupon payment structure. They may also have call provisions to allow for early prepayment if prevailing rates change. Corporate bonds are a major source of capital for many.
A company needs to have some consistent earnings potential to be able to offer debt securities to the public at a favorable coupon rate. The higher a company's perceived credit quality, the easier it becomes to issue debt at low rates and issue higher amounts of debt.
Corporate bonds are fully taxable at the federal, state and local levels – a chief difference between this kind of bond and municipal bonds or treasury bonds. Most of them are taxable with terms of more than one year. This is another reason corporates usually generate higher interest payments than these potentially tax-exempt bonds.
Corporate debt that matures in less than one year is typically called “commercial paper”.
These bonds can be quite secure or sometimes risky. Their inherent value is greatly determined by the credit worthiness of the corporation offering the bonds. Be aware that corporate stability can change over time. For example, until 2009, most bonds offered by U.S. automakers implied good levels of security. However, the bankruptcies of GM and Chrysler, combined with serious financial problems at Ford (F), generated much higher risk factors for their corporate bonds. Typically, however, corporate bonds are more secure than corporate stocks.
To buy corporate bonds
Corporate bonds trade in dealer-based, over-the-counter markets. In over-the-counter (OTC) trading, dealers act as intermediaries between buyers and sellers. Corporate bonds are sometimes listed on exchanges (these are called “listed” bonds) and electronic communication networks. However, vast majority of trading volume happens over-the-counter.
Corporate bonds can be bought through a full-service or discount broker, a commercial bank or other financial intermediaries. The best time to buy a corporate bond is when interest rates are relatively high.
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