Allow me to paint a picture for you: You're doing well in your professional life—maybe you're even thinking about retiring in ten or fifteen years—and you have extra income that you want to know what to do with. While you could just toss it all in a savings account for safekeeping, such an account is hardly high yield and offers little in the way of interest or growth. You want to invest some of your hard-earned money in something that can offer higher yields in the long-term. You could try your hand at the stock market, but stocks can be incredibly high risk, and your broker will take a cut of anything you earn anyway. If this scenario describes you in any way, then investing in bonds is a perfect fit for your needs. You can choose to invest in corporate bonds or government bonds, with the former having higher bond prices and higher risk but a higher interest rate than the latter. In this article, I will discuss all you need to know to enter the world of corporate bonds.
What exactly are corporate bonds?
Before you decide whether you want to invest in corporate bonds, you should certainly make sure you understand what you're getting into. Before we discuss corporate bonds in particular, it's important to understand exactly what a bond is. In simplest terms, a bond is a loan that must be paid back with interest. Unlike most loans in your life, however, purchasing a bond means you act as the bank, and the other party (the national government, a local government, or a privately owned company) must pay you back with interest after an agreed-upon time limit. The time limit can range from a few years to a few decades, with longer durations typically offering better interest rates.
Corporate bonds take many forms, as they can be issued by any company: large companies like General Electric, Toyota, and Verizon can offer bonds, but so can any small business like Joe Schmo's Car Dealership. All companies use bonds for the same reason, which is essentially to build capital to fund various projects. The idea behind a corporate bond is that the money from the bonds you purchase will be used by the company to make more money, and then the company is able to pay back however much you lent them plus a little extra for your troubles.
Larger, publicly traded companies will tend to have good credit ratings (more on that later) which mean that they are more reliable investments with relatively low-interest rates. Smaller, untested companies will offer higher interest rates because the investor is taking a greater credit risk by supporting them. In other words, there's a bigger chance a smaller company will be defunct and unable to honor your bond by the time it matures in five or ten years, but if the company does well, you will earn back considerably higher interest on your investment in exchange for the higher risk.
US government bonds are used to support the national treasury, and they are the most reliable form of bond you can purchase. However, they have among the lowest interest rates of any bonds, and they take decades to fully mature. Aunts or grandmothers will often buy a bond from the government for a newborn baby, so you may have a thirty-year bond that was purchased for you when you were born. The maturity dates for these bonds are typically twenty years after they are purchased, but they continue to accrue interest for thirty full years. While they make good gifts, they accrue so little interest and take so long to mature that they are not well-suited to most investors.
Various ratings agencies apply letter grades to companies offering bonds. These letter grades range from "C" to "AAA" and correspond with the expected reliability of the company issuing the bond in regards to its ability to pay back the value of the bond plus interest. AAA is the highest rating, with AAA-rated companies delivering on their issued bonds without default in over 99 percent of cases since 1920. Most investors consider BBB to be the lowest grade worth investing in. This rating system is separate from US government bonds, which will pretty much never default, even in times of economic hardship.
How do I invest in corporate bonds?
The most straightforward way to invest in corporate bonds is to go through a broker or issuing company representative. An investment broker is able to stay in touch with companies who are currently interested in issuing bonds. There are several online brokerage firms to help you invest in bonds online, so you will want to do some research to decide which is the best fit for you, keeping in mind that the services they offer (and what they charge for those services) can vary drastically. If you prefer to buy a bond in person, you can seek out a brick and mortar brokerage office near you and schedule an appointment. Finally, your local bank will likely be able to help with learning how to invest in commodities such as bonds and put it into practice as well. Depending on your bank, it may or may not able to help you directly with purchasing bonds, but your bank representatives will at least be able to get you in touch with a dedicated brokerage firm.
The other, more complicated way to invest in corporate bonds is to do so by way of mutual funds. Investing in mutual funds that center around corporate bonds rather than investing directly in the bonds themselves carries its own set of risks, but it offers one distinct advantage: diversification. Using different types of diversification when investing is one of the best ways to ensure their long-term success, especially with changing market conditions. However, if you are investing in bonds on an individual basis, you are looking at a lot of time and a lot of investment capital in order to maintain a truly diverse bond portfolio. By investing in this sort of mutual fund, also known as a bond fund, you can be more economical with your investment while still experiencing the benefits that come with diversification.