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What are Corporate Bonds and How Do You Evaluate Them?

By: , dated January 25th, 2013

Bonds issued by a corporation are called corporate bonds. When a company needs to raise funds for some type of investment or expenditure, they often turn to the public markets for funding. One way to do this is to issue additional stock in the company, but this has implications on the value of the shares and dilutes ownership. The other major option is to sell bonds to the public and take on debt. Selling bonds is often more attractive to companies than getting a loan from a bank.

Corporate bonds are very common and you can find prices and other information in the financial or business sections of major newspapers. Most corporate bonds have a par value of $1,000 and carry various maturity dates. Generally, these bonds pay higher rates than government or municipal bonds due to the increased risk. Corporate bonds have a wide range of ratings and yields because the financial health of the issuers can vary widely. All companies are different and have a different likelihood of defaulting on their obligations. For example, an old economy blue chip is far less likely to default than a new technology company. The blue chip’s bonds might carry an investment-grade rating, such as AA. Meanwhile, the less stable company might issue bonds rated in the junk category. These junk or “high yield” bonds might look like the superior investment on paper because they will command a higher yield for the bondholder. However, taking into account the increased risk of default (which would result in the bondholder going unpaid), these bonds might not be worth the risk.

If a company goes bankrupt, both bondholders and stockholders can make a claim on the company’s assets. However, one of the benefits of being a bondholder is that your claim takes precedence over that of stockholders in a liquidation situation. Additionally, some corporate bonds are “secured.” This means that the debt obligation is backed by some asset that can be liquidated in order to pay off the interest and principal. Corporations will often issue mortgage bonds, which are backed by real estate or physical equipment. These bonds are safer than unsecured bonds, which are backed only by the “full faith and credit” of the company – which basically means you are taking their word for it.

Most corporate bonds are straightforward with a fixed coupon rate that doesn’t change until maturity. There are some variations, however. Some bonds will have a floating rate, which means the interest paid in the coupon will be pegged to some independent index like the money market interest rate or the rate on a short term Treasury Bill. While these bonds insure you against a change in interest rates, they tend to offer lower yields. Another type of bond that might be issued is a zero coupon bond, which has no interest payments at all prior to maturity.

Here is a brief look at what to consider when evaluating corporate bonds (click on each term to learn more):

The way in which these factors interact with your investment goals and risk tolerance should provide the necessary guidance to make the proper investment. Generally, people are interested in corporate bonds if they are investing for a tax-deferred account or are in a low tax bracket. Municipal and government bonds have tax benefits that corporate bonds do not. However, because they offer a higher yield, corporate bonds can sometimes have a higher after-tax yield. Braver souls with a tolerance for risk might be attracted to the lower-grade junk bonds for their high yields. It is rare that a municipal bond sinks to the junk bond status, so corporate bonds are the only place to go for these higher yields. If you are interested in the risks associated with holding bonds, visit the front page of our bond education section.

Convertibility

Many corporate bonds are convertible bonds. These bonds can be exchanged for some specified amount of common or preferred stock in the issuing company. At the time of issue, the terms of conversion will be outlined, including the times, prices, and conditions under which it can occur. Most convertible bonds are also callable. This means, in effect, that the company can force bondholders to convert their bonds into stock (called “forced conversion”).

Convertibility affects the performance of the bond in certain ways. First and foremost, convertible bonds tend to have lower interest rates than non-convertibles because they also accrue value as the price of the underlying stock rises. Therefore, convertible bonds offer some of the benefits of both stocks and bonds. Convertibles earn interest even when the stock is trading down or sideways, but when the stock prices rises, the value of the convertible increases. Convertibles, therefore, can offer protection against a decline in stock price. Because they are sold at a premium over the price of the stock, convertibles should be expected to earn that premium back in the first three or four years after purchase. In some cases, convertibles may be callable, at which point the yield will cease.

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