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Understanding corporate bonds

Bonds offer a low-risk investment alternative to the stock market. If you’re looking for a way to earn capital returns and minimise the risk of losses, it’s worth considering investing in corporate bonds. Here’s what you need to know before getting started.

What is a corporate bond?

While some other types of bonds are issued by the government, corporate bonds are issued by businesses. But while purchasing stock in a company gives you a stake in the business, a bond is a debt instrument. This means that when you buy corporate bonds, you’re essentially loaning money to the businesses involved.

Like any business loan, bonds come with a fixed term and interest yield. When the term ends or the bond matures, the business repays the bond holder. Investors might also receive annual cash interest payments along with the principal sum at the term’s end.

How do corporate bonds work?

Corporate bonds work as loans to a business for a predetermined length of time. Terms can vary with corporate bonds, but they clearly state the term length, interest rate, and interest payment agreements at the time of purchase. Most will pay interest once or twice per year, and then repay the initial investment at the time of bond maturation.

As an example of how corporate bonds work, imagine you’ve invested $1,000 in a 10-year fixed-rate bond with a 4% interest rate. This means that you’d receive a $40 interest payment per year, along with the initial $1,000 repayment at the end of the 10 years.

There are other types of bonds that don’t have fixed rates, however:

  • Floating rate bonds: Interest rate payments change depending on predetermined benchmarks.

  • Zero coupon bonds: These don’t offer interest payments. Instead, you buy the corporate bond below its face value and receive the full value at maturity.

  • Convertible bonds: Companies have the flexibility to pay investors back in a different way when the bond matures, such as with stock.

How to buy corporate bonds

There are three main ways to purchase funds.

1. New issue bonds

This is the most straightforward way to buy corporate bonds directly from the company. As the name suggests, new issue bonds aren’t previously owned. You’ll purchase them at face value.

2. Secondary market

When you buy corporate bonds through the secondary market, this means you’re purchasing bonds that have already been issued from other investors. They’ll be trying to unload the bond before its maturity date. At this stage, bonds won’t always be offered at face value – they may be higher or lower depending on the issuing company’s financial condition.

3. Bond fund

If you have smaller amounts of capital to invest, it might be worth looking into a bond fund. Bond funds package corporate bonds together so that a larger group of investors can take part. These provide an easy way to diversify your portfolio, and the minimum buy-in is often cheaper than purchasing a bond outright.

How to choose corporate bonds

There are several factors to consider before you buy corporate bonds:

  • Credit rating: Does the company issuing the bond have a high credit rating? Essentially, how likely is the company to default on the loan? Corporate bonds from companies with low credit ratings are called junk bonds, and they carry a much higher investment risk.

  • Corporate bond rates: What is the interest rate? This should be clearly listed. Usually, longer-term bonds will carry higher interest rates.

  • Diversification: As with any investment, it’s important to diversify your portfolio. Look for bonds in a variety of industries to minimise your risk.

The bottom line

There are pros and cons to investing in corporate bonds. From the business’s perspective, issuing bonds offers an easy way to obtain funding. For investors, corporate bonds offer greater stability than the stock market. To further boost this stability, it’s important to do your research first to purchase bonds from companies with a good credit rating.

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