A diverse portfolio is one that contains a variety of assets, including stocks and bonds. While bonds aren't necessarily the most lucrative investment out there, what they lack in higher returns, they make up for in stability.

The bond market is actually made up of different types of bonds. There are Treasury bonds issued by the U.S. government, municipal bonds issued by states, cities, and counties, and corporate bonds issued by -- you guessed it -- corporations looking to raise capital. Here, we'll take a deep dive into corporate bonds to help you determine whether they're right for you. We'll review key terms you need to know, like maturity dates, interest rates, and credit ratings, so that you understand how corporate bonds work. We'll also show you how to evaluate bonds on a case-by-case basis and develop an investment strategy around them.

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How do corporate bonds work?

A bond is a debt instrument issued by an entity to raise money. In the case of a corporate bond, the entity in question is a corporation looking to raise capital for a host of reasons, whether to expand, upgrade equipment, or invest in research and development.

The best way to think about corporate bonds from an investor standpoint is to liken them to an I.O.U. When you buy bonds, you're essentially lending money to a company for a predetermined period of time, known as a bond's term. That period might be two years, five years, or 10 years, depending on the company's needs. The company, in turn, agrees to pay you a specific amount of interest on that loan, and then repay your initial investment, or principal, once your bond matures, or comes due, at the end of its term.

For example, you might buy a 10-year, $20,000 bond paying 3% interest. The company that issues that bond will, in turn, promise to pay you interest on that $20,000 every six months, and then return your $20,000 after 10 years.

Why are corporate bond payments made semiannually? Back in the day, bondholders actually had to submit the physical coupons attached to their original bond certificates in order to collect the interest payments that were due to them. Going through that process on a monthly basis would be burdensome, but waiting a full year would result in a long lag between collecting interest payments. Hence, semiannual payments seemed to make sense then, and the tradition has since continued even though the payment of interest has since been digitized. 

However, this example is a basic representation of how corporate bonds work. Usually, when you buy corporate bonds, you'll lock in a fixed rate, and you'll collect the same interest payment annually (known as a coupon payment) until your bond matures. However, some bonds work differently.

Floating-rate bonds are bonds with variable interest rates that change based on outside benchmarks like the U.S. Treasury bill rate or LIBOR (short for the London Inter-bank Offered Rate, it's the rate used by world banks when charging each other interest on short-term loans). Floating-rate bonds are usually issued by companies considered below investment grade, or "junk" status. This means their credit ratings are exceptionally low, and they're thus considered a higher-risk investment.

There are also zero coupon bonds, which don't pay interest. Rather, you buy them below face value (meaning, the amount the issuer promises to ultimately repay) and receive their full value once they mature. For example, if you're looking at a zero coupon bond worth $5,000, you might pay just $4,000 for it, and then collect $5,000 once it comes due.

Finally, there are convertible bonds. These work just like regular fixed-rate bonds in that they pay interest regularly, only they come with the option to be converted into shares of stock (hence the name). The benefit of buying convertible bonds is that if stock prices rise, so too do bond values. At the same time, if stock prices fall, there's the option to hold your bonds until maturity and recoup your principal. That said, convertible bonds can be difficult to come by, as not all companies issue them, and because they offer the flexibility of being converted to stock shares, their interest or coupon rates are generally lower than what you'd get with a fixed-rate corporate bond.

How to buy corporate bonds

Because stocks are traded on public exchanges, they're pretty easy to buy and sell. Corporate bonds, on the other hand, do not trade publicly. Rather, they trade in a manner known as over the counter, which means they're purchased through a third party, like a broker. As such, it can be challenging to determine whether you're getting a fair price for the bonds you're buying. It's not illegal for brokers to sell you a bond above its face value, or for a broker to sell you a bond at a price that's much higher than its going rate.

The good news is that the Financial Industry Regulatory Authority (FINRA) regulates the bond market so that transaction prices do become available to investors at some point. However, that information isn't always as up to date as it could be.

None of this is a reason not to buy corporate bonds. However, it's something you, as an investor, should be aware of. It also speaks to the importance of working with a broker you can trust.

Another thing to keep in mind is that you can buy corporate bonds individually, or in the form of shares of a bond fund. With the former, you choose a company and buy bonds it has issued. With the latter, you buy into a fund that invests in corporate bonds, thereby getting the benefit of instant diversification. Remember, if you buy bonds from a single company and it fails to meet its financial obligations under those bonds (which we'll get into in a bit), you stand to lose money. If you buy into a bond fund and one issuer of 30 runs into money problems, the bulk of your investment will remain unaffected.

How to make money from corporate bonds

For the most part, there are two ways to make money by investing in corporate bonds. The first is to hold your bonds until they mature, and collect interest payments on them along the way. The second is to sell your bonds for a price that's higher than what you bought them for.

Going back to our example, say you buy a 10-year, $20,000 bond paying 3% interest for face value, or $20,000. In the first scenario, you'd hold that bond for 10 years, collect 3% interest a year, and get your $20,000 back after a decade. In the second scenario, you might have an opportunity to sell your bonds for $22,000, thereby banking the difference.

As noted earlier, there are exceptions to this formula. If you buy zero coupon bonds, for example, you profit by paying less than face value for your bonds and getting their full face value once they mature. Similarly, if you buy shares of a bond fund that goes up in value, and you sell those shares for a price that's higher than what you paid for them, you can profit that way.

Corporate bonds versus other bonds

Corporate bonds aren't the only type of bond out there. Another popular investment choice is municipal bonds, which are those issued by cities, states, and other localities. Municipal bonds work just like corporate bonds, with one key difference: the tax treatment of the interest payments you collect. When you receive corporate bond interest, it's considered taxable income. But when you collect municipal bond interest, it's always tax-exempt at the federal level, and if you buy bonds issued by your home state, your interest payments are free of state and local taxes as well. That said, corporate bonds tend to offer higher interest rates than municipal bonds, which can, in many cases, more than compensate for that tax exemption.

There are also Treasury bonds, which are bonds issued by the U.S. government. Also known as T-bonds, Treasury bonds have a maturity of 10 years or longer, and because they're backed by the credit of the U.S. government, they're considered virtually risk-free. T-bond interest is also tax-free at the state and local level, though you'll pay federal taxes on the interest you collect. And as is the case with municipal bonds, Treasury bonds tend to offer lower interest rates than corporate bonds.

Corporate bonds versus stocks

It's easy to lump stocks and bonds into the same category. After all, your goal in investing in either one is to make money. But in reality, the two are very different beasts. When you buy corporate bonds, you're making a loan to a company in exchange for interest payments or some other financial incentive. However, you receive no upside if the company performs exceptionally well.

When you buy stocks, on the other hand, you actually own equity in the company in question, and in the case of common stock, you get voting rights on how that company operates. In some cases, you also get to collect dividends, which are essentially a share of a company's profits. But don't confuse interest payments and dividend payments -- with the former, you're getting a preset amount as per a contract, or bond agreement, and with the latter, you're benefiting when the company you've invested in does well.

How to choose corporate bonds for your portfolio

Once you make the decision to invest in corporate bonds, you'll need to make sure you're buying the right ones. You'll therefore need to look at the following factors:

  • The term of your bonds
  • The price of your bonds
  • The credit rating of your bonds' issuer

First, let's talk term. The longer you're willing to lock your money away, the higher an interest payment you'll generally receive. At the same time, longer bond terms come with more risk, so you'll need to weigh the upside of a higher interest rate against the possibility of not getting to use your money for however long it is until that bond comes due. If you're investing for a far-off goal, like retirement, then a bond with a 10-year term might be a good way to go, especially if its interest rate is higher than what you'd get with a five-year bond by the same issuer. But if you have reason to believe you'll need your money sooner, you're better off sticking to shorter-term bonds.

Then there's the price of your bonds to consider. As stated above, it can be hard to know whether you're getting a fair price on your bonds, so as a general rule, be wary when you're being charged a price that's well above face value. At the same time, don't hesitate to ask your broker what his or her markup is on that bond. If you have a good relationship with your broker, that information should be easy enough to come by. At the same time, don't hesitate to comparison shop. If there's a specific bond you have in mind, get quotes from different brokers and see what's most competitive.

Finally, there's the credit rating of a bond's issuer to consider. A credit rating is a measure of a company's ability to make good on its obligations. The higher the rating, the less likely the issuer is to default on its obligations and cause you to lose money.

There are three well-known ratings agencies that rate bond issuers:

  1. Standard & Poor's (S&P)
  2. Moody's
  3. Fitch

S&P and Fitch use a similar system that rates bond issuers from least to most risky as follows:

  • AAA
  • AA
  • A
  • BBB
  • BB
  • B
  • CCC
  • CC
  • C
  • D (refers to bonds that are already in default)

The Moody's rating system differs slightly, as follows:

  • Aaa
  • Aa
  • A
  • Baa
  • Ba
  • B
  • Caa
  • Ca
  • C

From there, numbers or symbols are used to offer additional detail on an issuer's creditworthiness. S&P and Fitch use pluses and minuses for this purpose, while Moody's uses numbers. For example, a B+ rating from S&P is better than a B or B-, while a Ba1 from Moody's is a higher rating than Ba2 or Ba3.

As a general rule, the lower a company's credit rating, the higher an interest rate you'll snag when buying its bonds. That's because investors need to be rewarded for taking on that risk. Therefore, if you're looking at two different bond issuers with the same credit rating and same bond term, but one is offering a higher interest rate than the other, it might pay to go with that higher rate, all other things being equal.

Keep in mind that corporate bonds with a rating below BBB- by S&P and Fitch and Baa3 by Moody's are considered junk bonds. Also known as high-yield bonds, these bonds offer comparatively high interest rates, but with a substantially higher risk of default. While hedge funds are known to snatch up junk bonds, they're generally not an appropriate choice for the average investor, and they're certainly a dangerous move for newbies.

Also, remember that bond ratings have the potential to change over time. A company might start out with a high credit rating but encounter financial difficulties that cause its rating to change.

There's no need to panic if you buy bonds issued by a company that starts out with a Aaa Moody's rating but gets downgraded to Aa, as the latter is still a strong rating. Rather, be wary if the company issuing your bonds sees its rating drop to the point where it's hovering close to junk status. In some cases, it pays to sell bonds you own at a minimal loss rather than wait for an issuing company to completely default, thereby subjecting you to even greater losses.

Benefits of corporate bonds

One benefit of buying corporate bonds is that they're a relatively safe investment -- at least compared to stocks. Granted, the better job you do of researching the bonds you buy, the safer your investment will be, but know that on a general level, the bond market is far less volatile than the stock market.

Another benefit of buying corporate bonds is that they give you a fairly reliable stream of income, at least in the case of fixed-rate bonds. For example, if you buy a 10-year, $20,000 bond paying 3% interest, you can look forward to $600 of income each year, assuming the bond issuer is able to meet all of its obligations. The dividends you might get from stocks, by contrast, are not guaranteed -- meaning, stock issuers aren't contractually obliged to pay dividends, even when they're doing well financially.

Drawbacks of corporate bonds

One major drawback of investing in corporate bonds is having to lock your money away for what could be a lengthy period of time. Stocks, by contrast, don't require you to commit to a specific timeframe. That said, you're always free to sell corporate bonds before they come due. If you're able to do so at a point when the market is strong, you might make money -- or at least avoid losing money. But if you sell at a bad time because you need to free up your cash, you could be forced to accept a price below face value, or below what you paid, thereby resulting in a loss.

Another downside associated with corporate bonds is something called interest-rate risk. When you buy corporate bonds, you're agreeing to accept a certain interest rate for the entire term of that bond. But if the same company issues bonds later at a higher interest rate, your bonds automatically lose value because you're stuck with that lower, earlier rate, while new investors would rationally prefer to buy bonds from the same company (i.e., the same risk of default) that pay a higher interest rate.

For example, you might buy a 10-year, $20,000 bond paying 3% interest. If the same company issues a 10-year, $20,000 bond paying 4% interest six months into your bond's term, your bond value starts to sink, and you're stuck in a scenario where you're collecting a lower rate for years.

Another major issue with buying corporate bonds? You generally won't see anywhere close to the same return you'd get with stocks. And over time, that could affect your ability to accumulate wealth.

Between 1928 and 2010, stocks averaged an 11.3% return, while bonds averaged just 5.28%. That's quite the difference. Now let's say you invest $20,000 over a 10-year term at an average annual 5.28% return. After a decade, you'll have $33,457. But if you were to score an average annual 11.3% return instead, you'd be sitting on $58,342.

Additionally, because bonds trade over the counter, it's hard to know whether you're buying them at a fair price, and overpaying for bonds can easily eat into your profits. Furthermore, bonds are generally sold in $1,000 denominations, which means if you're starting out with a limited amount of money to invest, you could get priced out of the market if your goal is to buy individual bonds (whereas you can easily find individual stocks for well less than $1,000 per share).

Finally, although bonds are considered a safer investment than stocks, they're not without risk. If a company issues bonds, encounters financial difficulties, and doesn't have enough money to make its interest payments or repay your outstanding principal, you stand to lose money. Throw in the fact that you're losing a portion of your interest payments to taxes off the bat, and it's easy to see why some investors shy away from corporate bonds.

Are corporate bonds right for you?

Now that we've reviewed the ins and outs of corporate bonds, the question is: Are they a good investment for you? Of course, there's no cookie-cutter answer here, because it will depend on your personal needs and goals. But know this: Bonds are a good way to diversify, whether you're first starting out in the world of investing or have been at it for years. Imagine you invest in stocks and bonds, and the stock market experiences an extended downturn. If, at that time, you continue to collect bond interest, that money could help offset some losses you might inevitably have to take on the stock side of your portfolio.

That said, if you're relatively young, you might consider laddering your bonds so that you have different bonds coming due at different times. For example, rather than buy a 10-year, $20,000 bond, you might put $5,000 into a two-year bond, another $5,000 into a three-year bond, an additional $5,000 into a five-year bond, and your remaining $5,000 into a 10-year bond. This way, if interest rates go up during that 10-year window, or other investment opportunities arise, you'll have access to some of your money at various points throughout that decade.

Furthermore, while younger investors are generally advised to put more of their money into stocks and less into bonds, the opposite holds true for near-retirees. The reason? If you're planning to cash out your investments in the near future to pay your living expenses once you stop working, you won't have a lot of time to ride out a stock market downturn. But since the bond market is relatively stable, you're less likely to face losses when you need to sell your corporate bonds to access cash.

Along these lines, corporate bonds can be a smart investment for seniors during retirement. The regular interest payments you collect can serve as a welcome income stream at a time when you're no longer collecting a paycheck.

Ultimately, there's a good chance corporate bonds have some place in your portfolio. Think about your tolerance for risk, as well as your immediate and long-term objectives, and you'll probably find that corporate bonds can benefit you in a number of ways.