Corporate Bonds

Corporate bonds are essentially IOUs issued by companies. When you buy a corporate bond, you are lending money to the issuing corporation. In return for your loan, the company promises to pay you periodic interest payments, known as the 'coupon', over a set period. At the end of that period, on the 'Maturity Date', the company repays your original loan amount, called the 'principal' or 'Face Value'. Think of it as the big business version of lending a friend $100, where they agree to pay you $5 a year for five years and then give you your $100 back. For the company, issuing bonds is a common way to raise money for things like building a new factory, funding research, or refinancing other debts. This method of raising capital is known as debt financing, and it's an alternative to issuing stocks (equity financing). As a bondholder, you are a lender, not an owner, which is a crucial distinction with important implications for your risk and potential reward.

Understanding corporate bonds is all about getting to know their three key components. Once you grasp these, you've cracked the code.

A bond is defined by its core features, which are laid out in the bond's prospectus, the formal document describing the offering.

• Face Value (or Par Value): This is the amount of money the bond will be worth at its maturity. It's the principal amount of the loan that the investor gets back from the company. While bonds can be bought and sold on the open market for more or less than their face value, the face value itself is fixed. A common face value for a single corporate bond is $1,000.
• Coupon Rate: This is the interest rate the company pays to the bondholder, expressed as a percentage of the face value. If you own a $1,000 bond with a 5% coupon rate, you'll receive $50 in interest per year (5% x $1,000). These payments are typically made semi-annually (so, in this case, $25 every six months).
• Maturity Date: This is the date when the bond “matures,” and the company repays the bondholder's principal (the face value). Bond maturities can be short-term (under 3 years), medium-term (3 to 10 years), or long-term (over 10 years).

Let’s say you buy a new bond from “Gadgets Inc.” for $1,000.

1. Face Value: $1,000
2. Coupon Rate: 6%
3. Maturity: 10 years

This means Gadgets Inc. will pay you $60 every year for 10 years (typically in two $30 installments). After the 10th year, they will return your original $1,000. Over the life of the bond, you will have collected a total of $600 in interest plus your original $1,000 investment back.

While they might not have the explosive growth potential of stocks, bonds play a vital role in a well-rounded investment portfolio.

The primary attraction of bonds is their role as a fixed-income security. The regular, predictable coupon payments provide a steady stream of cash flow. This can be particularly appealing for retirees or anyone looking to supplement their income without having to sell their assets. This reliable income stream provides a comforting counterbalance to the price volatility often seen in the stock market.

In the corporate hierarchy, lenders get paid before owners. As a bondholder, you are a lender. This puts you higher up in the capital structure than stockholders. If a company faces financial distress or bankruptcy, it must pay its bondholders what they are owed before stockholders see a single cent. More often than not, stockholders get wiped out completely in a bankruptcy, while bondholders can often recover some, or even all, of their investment.

A smart investor always understands the downside. Bonds are safer than stocks, but they are far from risk-free.

This is the big one. Credit Risk, also known as Default Risk, is the chance that the company will fail to make its interest payments or repay the principal at maturity. To help investors gauge this risk, independent credit rating agencies like Moody's and S&P Global Ratings analyze a company's financial health and assign it a credit rating.

• Investment-grade bonds are issued by financially stable companies and are considered relatively safe.
• High-yield bonds (politely called) or “junk bonds“ (more bluntly) are issued by less stable companies. They offer higher coupon rates to compensate investors for taking on the significantly higher risk of default.

This is a more subtle but equally important risk. Interest Rate Risk is the risk that the market value of your bond will fall if overall market interest rates rise. Imagine you own a bond paying a 3% coupon. If the central bank raises interest rates and new bonds are now being issued with a 5% coupon, your 3% bond suddenly looks a lot less attractive. No one would pay you the full face value for it when they could buy a new bond with a better payout. Therefore, the market price of your bond would fall. The longer the bond's maturity, the more sensitive it is to this risk.

Inflation Risk is the danger that the fixed payments you receive from your bond won't keep up with the rising cost of living. If your bond pays a 4% coupon but inflation is running at 5%, your “real” return (your return after accounting for inflation) is actually negative. Your investment is losing purchasing power over time.

For the value investor, bonds are not just a “set it and forget it” asset. The legendary father of value investing, Benjamin Graham, advocated for a portfolio balanced between stocks and bonds, seeing the latter as a source of stability and a crucial part of an investor's ”margin of safety”. A true value investor approaches bonds with the same analytical rigor as stocks. They don't just chase the highest coupon rate. Instead, they perform a deep dive into the company's balance sheet and income statement to assess its ability to service its debt. The goal is to find bonds of financially sound companies that may be temporarily undervalued by the market, perhaps due to irrational fear or a general market downturn. By buying a bond at a discount to its intrinsic value, an investor can lock in an attractive yield to maturity while being confident that the risk of default is low. In essence, you're looking for a safe and predictable return, but you're not willing to overpay for it.