What they Are Companies sell bonds when they want to borrow money to grow and expand. They promise to pay your money back on a future maturity date and pay interest in the meantime. There are different kinds of corporate bonds. Some are secured by specific assets which you can seize if the company fails to pay interest or return the original principal amount when the bonds mature. Others that aren't secured are called debentures. They are merely a promise to pay you. Corporate bonds often also have added features. You might be allowed to convert your bonds into the company's stock, or the company might have the right to buy back the bonds before they mature.
How they Work You can buy corporate bonds through an investment dealer. Usually issued in denominations of $1,000 or $10,000, they come with short and long-term maturities. As with government bonds, a corporate bond's return - called the yield -- is made up of interest payments and any profit or loss you make when the bond matures or when you sell it on the open market. People sell bonds on the open market because you can't turn them in to the company for cash until the maturity date. You can make a profit on a bond when you buy it for less than its face value. When it matures, the difference between your cost and the face value is your profit. This mostly happens when the interest on a bond isn't attractive to other investors. The seller has to discount the bond - from say $1,000 to $900 -- to compensate for the low rate of interest it pays. If you buy it, you'll make a $100 profit when the bond later matures at its full face value. When added to the interest payments you will already have received, this profit pushes up your rate of return. That same bond you bought for $900 might make you a profit in another way. If you wanted to sell it before it matures, you might profit by selling it for $950. This might happen if interest rates have gone down. Since other investments aren't paying returns as high as before, you won't have to offer such a big discount to prospective buyers. So the best time to buy bonds is before interest rates go down! Corporate bonds often come with added features. These can be advantages or disadvantages. Here are some features you might find:
The Risks The key risks of corporate bonds are that the company will go out of business and you'll lose your investment, and that interest rates will rise and you'll lose if you have to sell on the open market. Corporate bonds are generally more risky than government bonds. Companies can only stay in business as long as they're profitable, while governments have a ready source of funds through taxes. If the company's credit rating worsens after you buy a bond, you might lose money if you sell. Investors will want to pay less for your bond to compensate for the extra risk they have to take.
The Rewards Since they're riskier, corporate bonds often pay higher returns than government bonds. This is often attractive to people who need to live on income from their investments. However, it's a good idea not to put all your money in higher yielding corporate bonds because of the higher risk that you'll lose your money. If interest rates are dropping, you can make a profit by selling your bond in addition to being paid interest. Convertible bonds - those that can be changed for a set number of company shares -- can rise sharply in value if the stock price rises high enough