What are corporate bonds and how do they work?
Corporate bonds can help companies raise capital while giving investors a defined interest-payment structure. However, returns and repayment depend on the issuer’s financial position, and bond values can change over time.
Key takeaways
Corporate bonds are:
- Debt securities issued by private and public corporations to raise capital for business needs.
- A legal promise by the issuing corporation to pay regular interest payments to bondholders before returning the original principal amount at maturity.
- Assessed by credit rating agencies to give investors a clearer view of the company's financial strength and default risk.
- An arrangement in which investors who purchase these bonds act as lenders, while the issuing corporation acts as the borrower.
What are corporate bonds?
When a large corporation needs funds to build a new factory or invest in research and development, it can either take out a traditional bank loan or issue new shares to the public. However, both options can be costly or dilute ownership for existing shareholders. As an alternative, the company may choose to borrow money directly from investors by issuing bonds.
Corporate bonds are standardised corporate loans divided into smaller portions and sold to investors. When you purchase a corporate bond, you lend money to a company for a set period.
Corporate bonds definition
The formal definition of a corporate bond is a debt security issued by a corporation and sold to investors to raise capital. These instruments are fixed-income securities, meaning they usually provide scheduled interest payments over a defined period. Unsecured corporate bonds are backed by the issuing company's overall creditworthiness and future cash flow, rather than the tax revenues that may support some government bonds.
Meaning of corporate bonds explained
To understand the meaning of corporate bonds, think of an IOU.
Imagine your close friend wants to open a neighbourhood pizza parlour, but they need $10,000 to buy a commercial pizza oven. They ask you for a loan, and you both sign a simple agreement. The contract states that your friend will hold your $10,000 for five years. Each year, they will pay you $500 as interest for using your money. At the end of the five years, they will return your original $10,000 in full.
In global financial markets, that pizza shop owner is a large corporation, your handwritten contract is a corporate bond, and the annual interest payments are coupon payments.
A corporate bond is therefore a formal financial contract in which an investor lends money to a corporation in exchange for regular interest payments and the return of their initial investment on a specific date, provided the issuer can meet those obligations.
How does a corporate bond work?
A corporate bond works through clear, standard features that define its terms and influence its market value.
Face value
This is the principal amount the bondholder receives when the bond matures. A standard individual corporate bond is typically issued with a baseline face value of $1,000.
Coupon rate
The corporation promises to pay the investor a fixed annual interest rate. If a $1,000 bond has a 5% coupon rate, the company pays $50 in interest each year, usually split into two semi-annual payments.
Maturity date
This is the date when the corporate loan ends, and the company must repay the entire face value to the investor. Bonds can range from short-term, under three years, to long-term, typically 30–40 years, although some issuers have sold bonds with even longer maturities.
Credit quality
Independent agencies, such as S&P, Moody's and Fitch, assess corporations on their financial stability. Higher-rated companies receive an investment-grade credit rating, which generally reflects lower default risk but often lower interest rates. Lower-rated companies receive a high-yield, or ‘junk bond’, rating, meaning they typically offer higher interest rates to compensate investors for the greater risk of default.
Why are corporate bonds important?
Corporate bonds can play a role in market liquidity, portfolio diversification, and corporate financing strategy.
For investors, they may sit between lower-risk savings products or government bonds and higher-risk assets such as shares. Bonds have historically provided higher interest yields than standard bank savings accounts or government bonds, while generally carrying less price volatility than individual stocks. However, this isn’t guaranteed, and outcomes vary by issuer, bond type and market conditions.
For companies, corporate bonds can offer financial flexibility. They allow businesses to secure funding at fixed rates over defined periods, which may help fund multi-year projects without relying only on bank lending or equity issuance.
For markets, corporate bond yields can also provide a broader indicator of sentiment towards the corporate sector. When yields on lower-rated corporate bonds rise sharply, it may suggest that markets perceive higher stress among businesses.
Can you trade corporate bonds with CFDs?
Some trading platforms may offer contracts for difference (CFDs) on bond-related markets, such as government bonds, bond ETFs or interest-rate-linked instruments. A CFD does not give you ownership of the underlying bond. Instead, it allows you to speculate on price movements without buying the bond itself.
This means CFD traders are not bondholders and do not receive coupon payments in the same way as investors who hold corporate bonds directly. Instead, the value of a CFD position depends on the movement of the underlying market, along with factors such as spread, overnight funding and leverage.
Bond-related CFDs may be used by traders who want shorter-term exposure to changing interest-rate expectations, credit conditions or broader market sentiment. However, CFDs are leveraged products, which means both profits and losses can be magnified. They may not be suitable for all traders, especially without a clear understanding of leverage, margin and risk management.
Real-world corporate bond example
Apple Inc.'s 4.100% Senior Notes due 8 August 2062 are one example of a corporate bond.
In August 2022, Apple raised approximately $5.5bn across several note tranches, including a $1.25bn portion of these 2062 Notes. The company stated that the funds could be used for share buybacks, dividends and general corporate purposes.
Here is how the bond works at a basic level:
- An investor who purchased the bond at issuance provided cash to Apple.
- Apple agreed to pay an annual coupon of 4.100% on the principal until maturity.
- The notes are due to mature on 8 August 2062.
- At maturity, the face value is due to be returned to bondholders, provided Apple can meet the bond’s terms.
Apple held a high investment-grade credit rating, AA+ from S&P, at the time of issuance. This indicated a relatively low, though not zero, assessed likelihood of missed payments.
FAQ
How to invest in corporate bonds?
Retail investors can buy and sell corporate bonds through online brokerage accounts. While individual bonds can be purchased directly, some investors use corporate bond ETFs or mutual funds, which bundle many bonds together for diversification with lower capital requirements.
What are the risks of investing in corporate bonds?
The primary risk is default risk, also known as credit risk, which occurs if a company cannot meet its interest or principal payments. Investors also face interest rate risk. When central banks raise interest rates, existing bonds with lower fixed coupons tend to fall in resale value on the secondary market.
What is the difference between corporate bonds and commercial paper?
Corporate bonds and commercial paper mainly differ by time horizon and funding purpose. Corporate bonds are long-term debt instruments, typically lasting from three to 30 years or more, and are often used to fund major capital projects, such as new factories or mergers. Commercial paper is a short-term funding tool, usually lasting from overnight to 270 days, with an average maturity of around 30 days. Companies typically use it to cover immediate cash needs, such as payroll or daily inventory. Corporate bonds are usually issued through registered, formal contracts, while commercial paper is an unsecured, short-term promissory note that’s typically exempt from full securities registration.