A corporate bond is a method of raising money from investors. Most companies issue corporate bonds as a way to finance their business activities. In return for an investment, the organization which issues the bonds promises to make an interest payment at regular intervals on the amount invested. Then, at the maturity date of the bond, the full principal invested into the corporate bonds is repaid.
Corporate bonds are one of many investment options which are available today. They are usually a conservative option for a portfolio, as the interest rate is usually locked on the investment principal over the life of the bond. Compared to government bonds, cash, or term deposits at a bank, the return of a corporate bond is typically higher.
At the same time a corporate bond is usually a more conservative investment than shares which may be issued by the same company.
List of the Advantages of Corporate Bonds
1. The payments of a corporate bond are structured.
Corporate bonds offer a structured compensation plan for investors, which provides a reliable source of income. Even though the returns of a corporate bond may not always be competitive to the returns of stocks or mutual funds, there is a reliable schedule of income to depend upon, which can then be used for making future investments. When relying on disbursements or dividends for this income, there are fewer guarantees.
2. Bond holders are classified as creditors and rank higher in subordination.
Shareholders may not be able to make a claim on their investments if a company goes out of business or files for a bankruptcy. Corporate bonds are classified as a debt, which gives bond holders the status of a creditor. They often rank higher than other creditors when assets are being distributed during a bankruptcy proceeding. In such a situation, the bond holder may not make a profit, though they have a better chance to recover some of their initial investment.
3. Pricing structures for corporate bonds are consistent.
You can purchase corporate bonds through public offers or security exchanges. These are referred to as the primary market and secondary market for bonds respectively. You’ll still receive a prospectus when purchasing corporate bonds privately and apply for a direct purchase. Many of these bonds, including private ones, can be sold on a securities exchange after they have been issued. There are fewer fluctuations in the pricing structure, which helps to stabilize a portfolio.
4. Some corporate bonds may be converted into stocks.
As a way to repay investors who purchase corporate bonds, some companies may offer stocks in lieu of cash payments. This may be part of the initial agreement during the investment. It may also be an option permitted as a way to improve the cash liquidity of a business that may be attempting to restructure its debt. When this occurs, the stocks can be sold in the secondary market with greater ease and at the current value of the stock. Under the right circumstances, investors could see a bigger return with this option.
5. The returns of a corporate bonds are usually better than other bonds.
There are several types of bonds available for investors to consider. Corporate bonds tend to provide a better return because they present more risk than other bond types. Purchasing treasury bonds or government bonds that have a specific guarantee presents a better chance to have a fully repayment over its lifetime. That is why corporate bonds are usually the only option available to investors who are looking for a potential reselling opportunity on the secondary market. In 2015, German-backed government bonds had an interest rate of -0.05%. Corporate bonds with a 7- to 10-year maturity were yielding over 3% at the same time.
6. There are multiple corporate bond structures to consider.
There are several types of corporate bonds available in the primary and secondary markets today. Some bonds have a maturity at 5 years or less. Others may mature at 12+ years. Some long-term bonds may have 20-year or 30-year maturity dates. There are fixed coupon rates that pay the same interest rate, usually annually, but some may offer twice-per-year payments. Step coupons allow the interest rate to change at predetermined times.
7. You have a predictable source of income.
Most corporate bonds offer a predictable schedule for their payments, which allows you to plan in advance for the payments which will be received. An investment product, like a bond fund, may offer payments more frequently, though the payments are also more unpredictable. If your portfolio requires specificity with the income payments you receive, corporate bonds are a good combination of risk and reward to grow wealth over time.
List of the Disadvantages of Corporate Bonds
1. Corporate bonds rarely provide capital growth.
Bonds are not designed to increase in value during the time they are held. Although some may increase in value (or decrease) on the open market due to changing economic conditions, the goal of a bond is to provide structured interest payments while returning the principal to the investor over time.
2. Bonds can be defaulted on.
Just because there is less risk with a corporate bond does not mean there is zero risks. Corporations may sometimes default on their bonds because they no longer have the ability to pay their bills. When this occurs, there may be few options for a bond holder to recover their initial principal. Unlike other forms of debt that are taken on, the prospectus outlines the potential risks of the investment to each investor. If the company just goes out of business, it may be difficult to recover funds.
3. It is a financial resource that can be difficult to sell.
Even though corporate bonds can be resold to others, the economic conditions must be almost perfect for that to happen for an investor. That is because other investors want to make a profit off the investment, which means the initial investor would need to take a loss on the transaction. The only way for the initial investor to make a profit, plus give a discount on the sale, would be to have interest rates rise enough on bonds to make that happen.
4. Secondary markets have fewer buyers than primary markets.
Because of the repayment structure of a corporate bond, there may be zero buyers in the secondary market for some bonds. If an investor wants to add these bonds to their portfolio, they are almost forced to look at the primary market, review each prospectus, and make the best possible choice from available options. That process requires a time commitment which some investors may not have.
5. It relies on interest rate stability for profitability.
Corporate bonds are based on the current interest rates that are available within their market. If the interest rate is at 1%, then it will continue to be at that percentage throughout the life of the bond. If interest rates rise during the repayment period of the bond, then the profits available to the investor become less. In some situations, interest rate changes can be dramatic enough to eliminate any profitability from the corporate bond, forcing the investor to hold onto a product until it reaches the end of its life.
6. A larger investment is required to purchase a corporate bond.
The minimum purchase amount for a corporate bond depends upon the issuer. Although some corporate bonds may be issued for as little as $1,000, some corporate bonds may have a required minimum buy-in of $25,000 or more. Those investment minimums do not apply to stocks, where an individual can purchase a single share at the market rate if they wish. That structure gives some low-level investors fewer opportunities to get involved in this processor.
7. Bonds require you to ladder your portfolio.
For corporate bonds to be an effective income resource, you must do more than manage the risks of each investment. You must also ladder your portfolio to have different bonds with different maturity dates. Then you must record each interest check when it comes in, deal with situations when a bond is called by the company, and the potential tax complications which occur with each action.
8. Payments are infrequent for bonds.
Most corporate bonds will only pay once per year. If an investor were to look at bond funds instead, there is a good chance that monthly payments would be received instead. Even high-dividend stocks would likely offer 4 payments per year instead of just one. For investors who require frequent deposits to take care of their daily expenses, corporate bonds may not offer the flexibility that is required.
The advantages and disadvantages of corporate bonds must be carefully evaluated by each investor before making an investment decision. A careful review of each prospectus is necessary before making the decision to invest. Any advice presented here is for general information purposes only and is not a specific recommendation to invest into corporate bonds or any other type of investment.