A corporate bond is a loan you make to a company, and the company pays you back with interest
When you buy a corporate bond, you are lending money to a business. The company promises to pay you back the full amount on a specific date — called the maturity date — and to pay you interest along the way. That interest is called the coupon. You are not buying a piece of the company the way you would with stock. You are a creditor, not an owner.
The company uses the money it raises from selling bonds to fund operations, build facilities, pay off other debts, or make acquisitions. You receive regular interest payments, usually twice a year, until the bond matures. At maturity, the company returns your original investment, called the principal.
Corporate bonds trade on the secondary market, meaning you can sell a bond before it matures if you need the cash. The price you get depends on interest rates, the company's financial health, and how much time is left until maturity.
Key Takeaways
- A corporate bond is a debt security issued by a company that pays you fixed interest payments and returns your principal at maturity.
- Interest payments, called coupons, are typically paid twice per year and are usually higher than what you would earn from a savings account or Treasury bond.
- Corporate bonds carry more risk than government bonds because companies can default, but they also offer higher potential returns.
- You can sell a corporate bond before maturity on the secondary market, though the price will fluctuate based on interest rates and the company's credit quality.
- Bond ratings from agencies like Moody's and Standard & Poor's help you understand the risk that a company will fail to pay you back.
How interest payments work on corporate bonds
When you buy a corporate bond, the interest rate is set at the time of issue. If you buy a bond with a 5% coupon, you receive 5% of the bond's face value each year, split into two payments. A bond with a $1,000 face value and a 5% coupon pays you $50 per year, or $25 every six months.
The coupon rate does not change even if interest rates in the economy rise or fall. This is why bond prices move in the opposite direction of interest rates. If you own a bond paying 5% and new bonds start paying 6%, your bond becomes less attractive, so its price drops if you try to sell it. The reverse is also true: if new bonds pay only 3%, your 5% bond becomes more valuable.
Interest payments continue until the maturity date, when the company returns your full principal. If you hold the bond until maturity, you get back exactly what you paid for it (assuming the company does not default).
The difference between investment-grade and high-yield bonds
Investment-grade bonds are issued by companies with strong financial health and a low risk of default. These bonds carry ratings of BBB or higher from Standard & Poor's, or Baa3 or higher from Moody's. They pay lower interest rates because the risk is lower.
High-yield bonds, also called junk bonds, are issued by companies with weaker finances or higher debt loads. They carry ratings below BBB or Baa3. These bonds pay much higher interest rates to compensate you for the greater risk that the company might not pay you back. A high-yield bond might pay 8% or 10%, while an investment-grade bond might pay 4% or 5%.
The choice between them depends on your comfort with risk. Investment-grade bonds are more stable but offer lower returns. High-yield bonds offer higher returns but carry a real possibility that you could lose money if the company defaults.
What happens if a company defaults on a bond
If a company cannot pay the interest or principal on its bonds, it has defaulted. When this happens, you may lose some or all of your investment. The company might restructure its debt, paying bondholders a fraction of what they are owed, or it might file for bankruptcy.
In bankruptcy, bondholders are paid before stockholders. Secured bondholders — those whose bonds are backed by specific company assets — are paid before unsecured bondholders. But there is no may provide you will recover your full investment. The order of repayment and the amount recovered depend on the company's assets and the terms of the bankruptcy.
This is why bond ratings matter. A bond rated BBB is far less likely to default than one rated B or CCC. Before you buy a corporate bond, check its rating to understand the risk you are taking.
How to buy and sell corporate bonds
You can buy corporate bonds through a brokerage account at firms like Fidelity, Charles Schwab, or Vanguard. You can also buy them through a financial advisor. Most individual investors buy bonds through bond funds or exchange-traded funds (ETFs) rather than individual bonds, because funds spread the risk across many bonds and require less money to start.
If you buy an individual bond and hold it to maturity, you do not need to worry about price fluctuations. You get your interest payments and your principal back on schedule. If you need to sell before maturity, you can do so on the secondary market, but the price will depend on current interest rates and the company's credit quality at that moment.
Bond prices are quoted as a percentage of face value. A bond quoted at 102 means you pay $1,020 for a $1,000 bond. A bond quoted at 98 means you pay $980. The difference between what you pay and what you receive at maturity is part of your total return.
Why companies issue bonds instead of borrowing from banks
A company could borrow money from a bank, but issuing bonds allows it to borrow from many lenders at once and often at a lower cost. Bonds also give the company flexibility: it can issue bonds with different maturity dates and interest rates to match its needs. A company might issue some bonds that mature in 5 years and others that mature in 30 years.
For investors, bonds offer a predictable income stream. Unlike stocks, which pay dividends that can be cut or eliminated, bond interest payments are a legal obligation. The company must pay you or face default.
Corporate bonds versus other fixed-income investments
Corporate bonds typically pay higher interest than Treasury bonds or municipal bonds because they carry more risk. A Treasury bond is backed by the U.S. government, which has never defaulted. A corporate bond is backed only by the company's ability and willingness to pay.
Savings accounts and money market accounts are safer than corporate bonds but pay much lower interest. Certificates of deposit (CDs) offer rates between savings accounts and bonds, but your money is locked up for a set period.
The choice depends on how much risk you can tolerate and how long you can leave your money invested. If you need safety and do not mind low returns, Treasury bonds or savings accounts are better. If you can accept some risk and want higher returns, corporate bonds may fit your goals.
Frequently Asked Questions
Can a corporate bond be called before maturity?
Yes. Some corporate bonds include a call provision, which allows the company to pay off the bond early if interest rates fall. If your bond is called, you get your principal back but lose the higher interest payments you were counting on. Check the bond's prospectus to see if it is callable.
What is the difference between a bond's coupon rate and its yield?
The coupon rate is the interest rate set when the bond is issued and does not change. The yield is the return you actually earn, which depends on the price you pay. If you buy a bond at a discount, your yield is higher than the coupon rate. If you buy at a premium, your yield is lower.
Do I have to hold a corporate bond until maturity?
No. You can sell a corporate bond on the secondary market at any time. However, if you sell before maturity, the price you receive depends on current interest rates and the company's credit quality. You might receive more or less than you paid.
Are corporate bonds taxed differently than stocks?
Yes. The interest you receive from a corporate bond is taxed as ordinary income at your regular tax rate. Stock dividends may may have access to for lower capital gains tax rates. If you hold a bond in a tax-advantaged account like an IRA, you do not pay tax on the interest until you withdraw the money.
What does it mean when a bond is trading at par, a discount, or a premium?
Par is the face value of the bond, usually $1,000. A bond trading at a discount costs less than par, often because interest rates have risen since the bond was issued. A bond trading at a premium costs more than par, usually because interest rates have fallen and the bond's higher coupon is now attractive.