Corporate bonds and how they work

Why are corporate bonds used? 

There are multiple reasons why corporate bonds make sense from an investor’s perspective. Firstly, they can provide regular coupon income, though income is not guaranteed and bond prices can fluctuate. Secondly, corporate bond yields are often higher than government bond yields, but note that the difference varies and reflects credit risk and market conditions. On the flip side, greater yields often come with greater risk attached, particularly if the rating of your chosen corporate bond is on the low side.

Bond prices are sensitive to interest rates, and some investors adjust bond exposure based on rate expectations. For example, if you believe the Federal Reserve is likely to hike the base rate, you may choose to avoid investing in bonds once rates move above the coupon rate of a bond. Similarly, if you feel the Federal Reserve was to slash the base rate soon, it could be an opportune moment to find corporate bonds that are higher than the potential future interest rate, offering a better overall return.

If you decide to invest in a corporate bond and a few years down the line you want to get out, this is doable. The corporate bonds market has a secondary market, where you can sell off your initial investment before maturity. The secondary market is generally considered liquid, but liquidity varies by issuer, maturity and market conditions, and you may not be able to sell quickly or at the price you expect.

Understanding the quality of corporate bonds 

Before you jump to invest in corporate bonds, it’s important to educate yourself about the quality and risk of available bonds. Credit rating agencies will grade new corporate bonds issued by corporations, based on their fiscal fundamentals. If a company has a strong balance sheet and minimal debt, they are more likely to achieve a higher rating than a firm with dwindling cash flow and rising debt. 

A company’s corporate bonds are graded by credit rating agencies that use different rating scales (for example, AAA/AA/A/BBB etc., depending on the agency). Bonds are commonly grouped into investment-grade and high-yield/speculative-grade. These ratings are usually provided by three of the biggest credit rating firms– S&P, Moody’s, and Fitch. Each firm has its own methodology and ratings can differ between agencies.

Factors influencing the price of corporate bonds

There are multiple reasons why corporate bond values can fluctuate when traded in secondary markets. The appeal of certain corporate bonds can increase or decrease based on one or several of the following factors: 

Interest rates

The base rate of interest has a major bearing on the value of corporate bonds. They can also influence the supply and demand of corporate bonds. If the base rate of interest defined by the national bank is lower than a bond’s coupon rate, the bond may offer a higher yield than a savings account, but it involves different risks (including price and default risk).

However, if interest rates move above the bond’s coupon rate, demand will likely wane as investors seek better, more reliable returns elsewhere. Additionally, when interest rates are higher, companies themselves are more reluctant to issue bonds as the necessary yields to drive demand could prove too expensive. 

Credit rating

Although investing in corporate bonds is said to be one of the safer investment decisions, the reality is that companies can still default unexpectedly. We’ve already mentioned the rating scales of corporate bonds, which can extend down to ‘C’ and ‘D’ rated corporate bonds (how they are named depends on the credit rating agency). These bonds may be considerably cheaper than ‘A’ and ‘B’ rated corporate bonds, and some investors prefer higher-rated bonds, but the choice depends on objectives and risk tolerance. 

Corporate bonds are no different to many other securities in that their values are largely driven by market forces of supply and demand. Demand is influenced by the appeal of a bond, in relation to the attractiveness of other investment opportunities in the markets. 

Supply is influenced by a company’s commercial targets, as well as the cost of borrowing through other avenues. If a company has a major project that needs finance to get off the ground, issuing corporate bonds could be a way to turbocharge the first stage of the process. So long as interest rates aren’t too high, companies should consider bonds as a credible means of funding big-ticket schemes.

High inflation

Corporate bonds are not immune from the impact of high inflation. Higher inflation can put downward pressure on bond prices, particularly if interest rates rise. The reasoning behind this is two-fold. A bond's coupon rate is less appealing when inflation diminishes the return’s purchasing power. Let’s say that the yield on a corporate bond was 5%, but inflation was running at 7%. In real terms, you would be losing 2% on your investment.

In addition, higher inflation usually results in higher interest rates to combat inflationary environments. This too can force bond prices and market demand down.

Proximity to maturity

The price of a corporate bond is also intrinsically linked to its maturity. As maturity approaches, prices often move towards face value, but this depends on credit risk and market conditions, and the issuer could default. Newer bonds are more likely to take current interest rates into consideration. The price of longer-term bonds will fluctuate considerably through their lifespans, as economic conditions improve or worsen over time.

The benefits and risks of corporate bonds

To help you fully understand the benefits and risks attached to corporate bond investing and decide if it’s right for you, we’ve put together an extensive bulleted list of pros and cons.

Benefits of investing in a corporate bond

Debt instruments like corporate bonds can balance equity-heavy portfolios

Diversification is everything when it comes to a balanced investment portfolio. Corporate bonds can act as a hedge against investments in equities, as they typically move in the opposite direction to stocks.

Opportunities to profit on bond prices when the markets are volatile

Although corporate bonds are marketed as an income investment, speculation is still a viable option on corporate bonds too. With the fluctuation of bond prices based on interest rates and market volatility, there are opportunities to profit from buying and selling bonds via the secondary market.

Regular interest income

For those seeking a steady return on investment, higher-rated corporate bonds are often considered lower risk than lower-rated bonds, but it must be noted that they can still lose value and issuers can default.

Risks involved with corporate bond investing

Interest rate and inflation risk

Prospective hikes in interest rates can result in a decline in market value of bonds. Similarly, heightened inflation can erode the value of interest payments.

Issuing company repaying the bond’s principal prior to maturity

It’s entirely possible that your bond is repaid to you prior to maturity. If a corporate bond has a ‘call’ provision inbuilt, it means the business has the right to repurchase the bond and return the original investment at face value. This means you might not be guaranteed the interest payments through to maturity.

It may not be easy to sell off your bond holdings

The bond market is notorious for its lack of pricing transparency. Unlike the stock markets, it’s not easy to determine the appetite for buying bonds for those considering selling them on the secondary market. Liquidity can be an issue, although investment-grade corporate bonds are typically in high demand.

Credit risks can change over the lifetime of a corporate bond

There are no guarantees that a company won’t default on their corporate bonds. Even those deemed investment-grade may still experience financial difficulties and, worse still, bankruptcy. Fortunately, bondholders are deemed as creditors and often paid first during bankruptcy – even before shareholders.

How to buy corporate bonds

Individual corporate bonds

Retail investors may consider buying individual corporate bonds issued by specific companies. Typically, these bonds are issued in blocks of $1,000 at a time. They can be acquired via financial brokers and investment platforms. Most brokers will charge a commission on bonds purchased online.

At Saxo Bank we offer a global selection of corporate bonds. Commissions may apply and can change; check the latest pricing for your account tier.

Corporate bond funds

An alternative investment route is to buy into a corporate bond fund. There are some mutual funds and exchange-traded funds (ETFs) that offer exposure to multiple corporate bonds, allowing you to spread your risk across a host of sectors. Corporate bond funds also offer a lower barrier to entry, which can be a great starting point for those new to investing in bonds.