Corporations often need outside financing in order to grow, and one way to raise needed capital is by issuing bonds. If a business is planning to expand by buying land, building factories and purchasing equipment bonds are one way to do so. One advantage of bonds is that the principle is not paid back until the maturity date, giving the company time to start recouping returns on its investment before having to return the principal.
Bonds are debt instruments that work as follows. Imagine a company wants to raise, say, $1 million, and is willing to pay 5% per year interest on it (the coupon). The company issues the bond and agrees to repay it in, for example, five years (the maturity date). Many different investors buy the bonds, typically in portions of $1000 (the principal), so in this case 1000 bonds at $1000 each would be issued to raise $1 million . Buyers receive $50 per year interest on each bond (usually in two semi-annual installments) and at the end of the five year the principal of $1000 is repaid.
The above illustration describes fixed income bonds, but there are other ways to structure a bond. The interest rate paid on a “floating rate” bond is not fixed, it is tied directly to a specific market rate, often the rate a central bank is charging for money. Typically, there is a fixed spread between the two, but if the government alters their rate, the bond’s interest rate will follow it, either up or down.
But investors may not want to wait until the maturity date to redeem their principle, so there is a secondary market where bonds can be bought and sold. Continuing with the above example, imagine an investor wants their principle back after the first year. He is willing to sell the rights to that $1000 principle for $950 dollars. The investor that buys it would now be in line for $200 of interest over the next four years (4 years times $50 per year) plus the $1000 principle, for $950. The total return, then, would be 26% over four years ($250 profit on a $950 investment).
An alternative way to categorize bonds is according to risk. In general, corporate bonds are considered riskier than government bonds, since corporations can merely persuade customers to buy their products or services, while countries can force their citizens to pay higher taxes. On the other hand, government bonds generally provide lower returns since they are more secure. But not all corporate bonds are equally risky; some companies are more likely to be able to make their payments than others, and therefore different corporate bonds have different yields.
“Investment grade” bonds are issued by companies that less likely to default on payments. Because of the lower risk, the rate of interest paid on the principal is lower. These bonds are lower risk/lower reward. High-yield bonds, also known as “junk bonds,” are issued by companies that are considered at higher risk of defaulting on the interest payments or the principal. Because of the higher risk, these companies must pay a higher rate of interest in order to attract investors. Junk bonds are higher risk/higher reward.
Sadly for investors, profits made on corporate bonds are taxable. Profits are taxed as income, and the tax rate you will owe is the same as your marginal rate. So if you pay 20% in federal tax, and 6% in state tax, you will have to forfeit 26% of the income from the bond to the IRS.
Bonds can be a sound investment for investors interested in predictability, though the safer the bond, the lower the yield. Many investors need reliability; for example, retirees living on a fixed income and are frustrated by the short and medium term fluctuations in the stock market. Corporate bonds may be for you; but be beware, they are not risk free.