A corporate bond is a debt security that a company sells to investors in order to borrow money. The company promises to pay interest, usually at a fixed coupon rate, and to repay the face amount on a set maturity date. Companies use bonds to fund investment, acquisitions, share buybacks and the refinancing of older debt, often at a lower cost or for longer terms than a bank loan would offer.
Corporate bonds are one branch of the wider family of fixed income securities, alongside government and municipal debt. Their yields are normally higher than those on government bonds of the same term, because investors must be paid for the risk that the company fails. In the United States, public issues are registered with the SEC under the Securities Act of 1933, and the Trust Indenture Act of 1939 requires a written indenture with an independent trustee acting for bondholders.
Corporate bond in plain terms
A corporate bond is like a large company borrowing from thousands of people at once instead of from one bank. Each lender gets a slip of paper promising regular interest and the money back on a certain date. The slips are identical, so lenders can sell them to each other if they need cash before the end.
The interest a company has to offer depends on how trustworthy it looks. A steady utility borrows cheaply, much as a person with a long record of paying bills gets a good mortgage rate. A young or heavily indebted firm has to pay more to persuade anyone to lend.
How corporate bonds are issued and traded
A company that wants to borrow hires one or more investment banks to handle the underwriting. The banks gauge demand from institutional investors, agree a price and coupon, and place the bonds. Large US issuers often use a shelf registration that lets them sell new bonds quickly. Bonds sold only to large institutions under SEC Rule 144A skip full registration but can be resold only to qualified institutional buyers.
Once issued, corporate bonds trade over the counter through dealers. In the US, dealers must report trades to FINRA's TRACE system, launched in 2002, which publishes prices and has made the market more transparent. In Europe, issuers commonly list bonds on an exchange such as Luxembourg or Dublin, even though most trading still happens between dealers. Individual investors most often hold corporate bonds through a bond fund or an ETF.
Key terms in a corporate bond
Beyond the coupon and maturity, a bond's indenture sets out the details that decide what the investor actually holds:
- Seniority and security. Senior secured bonds are backed by specific collateral and are paid first in a bankruptcy; subordinated bonds rank behind other creditors but ahead of shareholders.
- Call features. A callable bond lets the company repay early, usually when rates have fallen, which caps the investor's gain.
- Covenants. Promises such as limits on extra borrowing or on asset sales protect bondholders; high-yield bonds usually carry more of them.
- Conversion rights. A convertible bond can be swapped for the company's stock at a set price.
- Floating or fixed rate. Floating-rate notes reset their coupon to a benchmark, formerly LIBOR and now usually SOFR for US dollar issues.
Credit quality and pricing
Corporate bonds are graded by rating agencies, and each credit rating places an issue in one of two broad groups. Investment-grade bonds are rated BBB- (S&P and Fitch) or Baa3 (Moody's) and above; anything lower is a junk bond, or high-yield bond. The extra yield over a government bond of the same maturity is the credit spread, which widens when investors grow nervous about the economy and narrows when they are confident.
A bond's price and yield to maturity therefore move with two forces: the general level of interest rates, which drives interest rate risk, and the company's own credit risk. Investors who want to hedge or bet on a company's credit separately can use a credit default swap.
Risks and limitations
The central risk is default: if the company cannot pay, bondholders may receive only part of their money after a restructuring or bankruptcy. Recoveries vary widely by seniority and industry. Corporate bonds are also less liquid than government bonds, so prices can fall sharply in a crisis, as in March 2020, when the Federal Reserve set up emergency facilities to buy corporate bonds and bond ETFs. Since 2008, a growing share of lending to mid-sized companies has moved away from bonds to private credit funds, which make loans directly and hold them rather than trading them.