Corporate Bonds: A Little More Risk, A Little More Reward

Bonds. And more specifically, corporate bonds. We’ve all heard of them at some point. But most of us probably had to Google the term “corporate bonds explained” to try to figure out what it actually is. Bonds can be a useful tool when investing. Especially if you are investing for either regular interest payments or want your investment to be relatively safe. So today, let me explain what bonds are, and more specifically, what corporate bonds are.

What Are Bonds?

Bonds are simply a loan that you (the investor) give to a government entity or to a corporation. Think of yourself as the bank and a government entity or corporation who is coming to you for a loan. It’s really as simple as that. 

With a bond, you (the investor) loan money and that money is returned to you in the form of interest payments (called coupons) for a specified period of time. At the end of that time, your original loan amount (investment) is returned. Let’s look at an example.

The company of Big State Imperialism wants to build a new manufacturing plant. They don’t have enough money to build it outright so they decide to issue a bond that looks like this:

• $10 million bond 
• With 5% coupons
• For 10 years

The $10 million bond will be split up into smaller $1,000 bonds for individuals to purchase.

Marcy decides she would like to invest in the bond. She decides that she will purchase a $1,000 bond for the new hospital. She gives the town her $1,000 and then she starts getting coupons (interest payments) for 10 years. At the end of the 10 years, she gets her original $1,000 investment back.

Marcy’s cash flows look like this:

Different Types of Bonds

There are two MAIN types of bonds:

1. Government bonds
2. Corporate bonds

Government bonds are used to fund items that the government needs. This can range from projects as large as building a new fleet of aircraft carriers for the military to as small as repairing the sidewalks in your subdivision.

Corporate bonds are bonds issued by (you guessed it) corporations. These bonds are used for a varying number of corporate tasks. These can range from paying down high-interest debt, cash flow shortages, business expansion, construction costs, etc.

Yes there are other types of bonds but they are outside the scope of this article. We’ll save GO and revenue bonds for another day.

What To Look For In Corporate Bonds

There are two main items to look for in bonds:

1. Creditworthiness
2. Yield

Creditworthiness

Just like you and I have a credit score, bonds have something similar. It is simply called a credit rating. The higher credit rating a bond has, the safer it is for investors. 

This is just like someone who has an 800 credit score is more likely to get a loan from a bank opposed to someone who has a 500 credit score. The person with an 800 credit score is much more likely to pay back their loan on time than the person with the 500 credit score.

Just like there are three credit bureaus that give each of us a credit score (Experian, TransUnion, and Equifax), there are three main credit agencies that give bonds ratings:

1. Standard and Poor’s
2. Moody’s
3. Fitch

The higher the grade, the more safe that bond is. The lower the grade, the more likely the bond will default and you will lose your original investment.

Here are the ratings for each of the bond agencies:

Moody’s	S&P	Fitch	Type of Bond	Investment/Junk
Aaa	AAA	AAA	Prime	Investment
Aa1	AA+	AA+	High Grade	Investment
Aa2	AA	AA	High Grade	Investment
Aa3	AA-	AA-	High Grade	Investment
A1	A+	A+	Upper Med Grade	Investment
A2	A	A	Upper Med Grade	Investment
A3	A-	A-	Upper Med Grade	Investment
Baa1	BBB+	BBB+	Lower Med Grade	Investment
Baa2	BBB	BBB	Lower Med Grade	Investment
Baa3	BBB-	BBB-	Lower Med Grade	Investment
Ba1	BB+	BB+	Speculative	Junk
Ba2	BB	BB	Speculative	Junk
Ba3	BB-	BB-	Speculative	Junk
B1	B+	B+	Highly Speculative	Junk
B2	B	B	Highly Speculative	Junk
B3	B-	B-	Highly Speculative	Junk
Caa1	CCC+	CCC	Substantial Risk	Junk
Caa2	CCC		Extremely Speculative	Junk
Caa3	CCC-		Default Imminent	Junk
Ca	CC	CC	Default Imminent	Junk
	C	C	Default Imminent	Junk
/	D	D	In Default	Junk

Yield

The second item to look for in corporate bonds is yield. Yield is simply the coupon rate that you will be given in exchange for the government entity or corporation borrowing your money.

These rates change all of the time but in the time of writing this (2021), rates are near all-time lows.

The important thing to know when concerning the yield of a corporate bond is that bond ratings and yields have an INVERSE relationship. 

For example, if you are going to invest in a AAA bond your yield (coupon) might be 2%. But if you are going to invest in a BB bond your yield (coupon) might be 6%. 

The reason for this is because the investor will want to be more highly compensated for investing in a less stable/riskier bond. If the bond is extremely stable (like an AAA) there is very little risk and therefore very little reward. The more risk that an investor takes, the more reward they will be given in the form of a higher yield.

Final Thoughts

Corporate bonds certainly aren’t for everyone. Not everyone who has investable money should invest in corporate bonds. They are typically considered a lower risk investment and therefore carry an overall lower return on investment. However, bonds certainly serve a good function in our society. In fact, if you pay local taxes, you are probably already invested in bonds through your tax dollars to pay for a high school, community center, roads and bridges, a hospital, etc.

And corporate bonds give companies a way to grow at a responsible pace while giving investors a decent return. 

I hope that this has helped give you one more piece of information to add to your financial literacy toolbelt!

If there is anything I can do for you, please don’t hesitate to let me know in the comments.

Until next time!