Corporate Bonds

Financial Dictionary -> Investing -> Corporate Bonds

A corporate bond is a type of bond issued by corporate entities. This definition excludes all other bonds that government authorities and other institutions offer in the United States. Corporate bonds are sold to investors with the aim of raising more money for expansion or other financing needs. Note that this type of financial instrument only encompasses products that have maturity of at least one year. If the same is issued with a shorter maturity period, it is referred to as commercial paper.

Corporate Bond as an Investment Instrument

In its nature, the corporate bond is a debt instrument, and the company's payment ability is its backing, typically in the form of profits from future operations. The physical assets of a business entity may also serve as collateral for corporate bonds.

These can be a profitable long term investment as long as the trader invests in the right company. In most cases, corporate bonds offer higher interest rates than bonds issued by municipalities or governments. However, earnings from the investment instrument are not tax-free. Bonds are typically subject to annual tax returns. In addition, corporate bonds come with higher interest rates, compared to government bonds. There is risk that the business entity goes bankrupt, defaulting on the bond, unlike government authorities which have the option of printing money when necessary. Most corporate bonds are in the form of debentures, i.e. they don't come with collateral. Investors have to assume both, interest rate and credit risk. While increase in interest rates can reduce the investment value, default will certainly eliminate it. Individuals who hold defaulted bonds may be able to recover some portion of the principle, but it is typically pennies on the dollar.

High-yield bonds, sometimes called junk bonds, are issued by corporate entities with below investment grade credit quality. Convertible bonds are a form of corporate bonds that may be converted into stock upon the satisfaction of certain requirements.

How to Invest in Corporate Bonds

In order to purchase bonds, companies and individuals have to work with investment brokers. When an investor uses the services of a broker, he has to pay for the current par value of the bond. If he chooses to buy bonds from a secondary market, then the price may be either lower or higher.

Another option is to invest in mutual funds that specialize in purchasing corporate bonds. If an individual does not have sufficient money for investment, the mutual fund offers a cheaper alternative. Since the latter represents a pool of money collected by an investment company from various investors, the cost of the purchase is more affordable. As long as the corporation which issued the bonds performs well, the investor enjoys significant returns.

The Term of the Bond

The maturity of a bond is typically in the range of one to five years; however, some types of corporate bonds come with a maturity of up to 20 or 30 years.

Investment Strategies

Investing in one type of instrument can be risky because there is no diversification. In order to enjoy good financial gains, it is best to invest in more than one corporate bond. In fact, it is also wise to invest in other instrument types including stocks, choosing between short-term and long- term instruments. This strategy presents a number of advantages because financial gains from bonds cannot be fully enjoyed until their maturity.