Investor BulletIn

What Are Corporate Bonds?

The SEC’s Office of Investor Education and Advocacy is company will default on its bonds. this “default risk”
issuing this Investor Bulletin to offer basic information makes the creditworthiness of the company—that is, its
about corporate bonds. ability to pay its debt obligations on time—an important
concern to bondholders.
What is a corporate bond?
A bond is a debt obligation, like an Iou. Investors who What are the basic types of corporate
buy corporate bonds are lending money to the company bonds?
issuing the bond. In return, the company makes a legal Corporate bonds make up one of the largest components
commitment to pay interest on the principal and, in of the u.s. bond market, which is considered the largest
most cases, to return the principal when the bond comes securities market in the world. other components include
due, or matures. u.s. treasury bonds, other u.s. government bonds, and
municipal bonds.
to understand bonds, it is helpful to compare them with
stocks. When you buy a share of common stock, you own Companies use the proceeds from bond sales for a wide
equity in the company and will receive any dividends variety of purposes, including buying new equipment,
declared and paid by the company. When you buy a investing in research and development, buying back their
corporate bond, you do not own equity in the company. own stock, paying shareholder dividends, refinancing
You will receive only the interest and principal on the debt, and financing mergers and acquisitions.
bond, no matter how profitable the company becomes or
how high its stock price climbs. But if the company runs Bonds can be classified according to their maturity, which
into financial difficulties, it still has a legal obligation to is the date when the company has to pay back the
make timely payments of interest and principal. the principal to investors. Maturities can be short term (less
company has no similar obligation to pay dividends to than three years), medium term (four to 10 years), or long
shareholders. In a bankruptcy, bond investors have priority term (more than 10 years). longer-term bonds usually
over shareholders in claims on the company’s assets. offer higher interest rates, but may entail additional risks.

like all investments, bonds carry risks. one key risk to a Bonds and the companies that issue them are also
bondholder is that the company may fail to make timely classified according to their credit quality. Credit rating
payments of interest or principal. If that happens, the agencies assign credit ratings based on their evaluation

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of the risk that the company may default on its bonds. What happens if a company goes
Credit rating agencies periodically review their bond ratings into bankruptcy?
and may revise them if conditions or expectations change.
If a company defaults on its bonds and goes bankrupt,
bondholders will have a claim on the company’s assets
Based on their credit ratings, bonds can be either
and cash flows. the bond’s terms determine the bond-
investment grade or non-investment grade. Investment-
holder’s place in line, or the priority of the claim. Priority
grade bonds are considered more likely than non-invest-
will be based on whether the bond is, for example, a
ment grade bonds to be paid on time. non-investment
secured bond, a senior unsecured bond or a junior
grade bonds, which are also called high-yield or specula-
unsecured (or subordinated) bond.
tive bonds, generally offer higher interest rates to com-
pensate investors for greater risk.
In the case of a secured bond, the company pledges specific
collateral—such as property, equipment, or other assets
Bonds also differ according to the type of interest pay-
that the company owns—as security for the bond. If the
ments they offer. Many bonds pay a fixed rate of interest
company defaults, holders of secured bonds will have a
throughout their term. Interest payments are called
legal right to foreclose on the collateral to satisfy their claims.
coupon payments, and the interest rate is called the coupon
rate. With a fixed coupon rate, the coupon payments stay
Bonds that have no collateral pledged to them are
the same regardless of changes in market interest rates.
unsecured and may be called debentures. Debentures
have a general claim on the company’s assets and cash
other bonds offer floating rates that are reset periodically,
flows. they may be classified as either senior or junior
such as every six months. these bonds adjust their
(subordinated) debentures. If the company defaults,
interest payments to changes in market interest rates.
holders of senior debentures will have a higher priority
Floating rates are based on a bond index or other bench-
claim on the company’s assets and cash flows than
mark. For example, the floating rate may equal the
holders of junior debentures.
interest rate on a certain type of treasury bond plus 1%.
Bondholders, however, are usually not the company’s only
one type of bond makes no interest payments until the
creditors. the company may also owe money to banks,
bond matures. these are called zero-coupon bonds, because
suppliers, customers, pensioners, and others, some of
they make no coupon payments. Instead, the bond
whom may have equal or higher claims than certain bond-
makes a single payment at maturity that is higher than
holders. sorting through the competing claims of creditors
the initial purchase price. For example, an investor may
is a complex process that unfolds in bankruptcy court.
pay $800 to purchase a five-year, zero-coupon bond with
a face value of $1,000. the company pays no interest on What are the financial terms of a bond?
the bond for the next five years, and then, at maturity,
pays $1,000—equal to the purchase price of $800 plus the basic financial terms of a corporate bond include its
interest, or original issue discount, of $200. Investors in price, face value (also called par value), maturity, coupon
zero-coupon bonds generally must pay taxes each year rate, and yield to maturity. Yield to maturity is a widely
on a prorated share of the interest before the interest is used measure to compare bonds. This is the annual
actually paid at maturity. return on the bond if held to maturity taking into
account when you bought the bond and what you
paid for it.

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2
A bond often trades at a premium or discount to its face What’s the relationship among bond
value. this can happen when market interest rates rise or prices, interest rates and yield?
fall relative to the bond’s coupon rate. If the coupon rate
the price of a bond moves in the opposite direction than
is higher than market interest rates, for example, then the
market interest rates—like opposing ends of a seesaw.
bond will likely trade at a premium.
When interest rates go up, the price of the bond goes
down. And when interest rates go down, the bond’s price
Financial Term Bond A Bond B Bond C goes up. As shown above, a bond’s yield also moves
Price (as a % of face value) 100 90 110 inversely with the bond’s price.
Maturity 10 years 10 years 10 years
For example, let’s say a bond offers 3% interest, and a
Face value $1,000 $1,000 $1,000
year later market interest rates fall to 2%. the bond will
Coupon rate 4.00% 4.00% 4.00% still pay 3% interest, making it more valuable than newly
Yield to maturity 4.00% 5.31% 2.84% issued bonds paying just 2% interest. If you sell the 3%
bond, you will probably find that its price is higher than
Bond A. Bond prices may be quoted in dollars or as a a year ago. Along with the rise in price, however, the yield
percentage of its face value. Bond A’s price is 100% of to maturity for any new buyer of the bond will go down.
the face value, or $1,000. the bond will pay 4% of the
face value, or $40 per year. Most bonds are paid semi- now suppose market interest rates rise from 3% to 4%.
annually, so Bond A will pay $20 every six months. In If you sell the 3% bond, it will be competing with new
addition, the bond will make a principal payment of bonds that offer 4% interest. the price of the 3% bond
$1,000 at the end of the 10 years. the bond pays a 4.00% may be more likely to fall. the yield to maturity for any
yield to maturity because it is not trading at either a new buyer, however, will rise as the price falls.
premium or a discount.
It’s important to keep in mind that despite swings in
Bond B. Bond B’s price is 90% of its face value, or trading price with a bond investment, if you hold the
$900. notwithstanding this, investors in Bond B will still bond until maturity, the bond will continue to pay the
receive a total of $40 per year in coupon payments and stated rate of interest as well as its face value upon
when Bond B matures, bondholders will still receive the maturity, subject to default risk.
face value of $1,000. the discounted price results in
Bond B having a yield to maturity of 5.31%. What are some of the risks
of corporate bonds?
Bond C. this bond sells for a premium at $1,100, or Credit or default risk
110% of face value. like Bonds A and B, investors in
Credit or default risk is the risk that a company will fail
Bond C will receive a total of $40 per year in coupon
to timely make interest or principal payments and thus
payments and the bond’s face value of $1,000 at maturity.
default on its bonds. Credit ratings try to estimate the
Because of the premium price, the yield to maturity on
relative credit risk of a bond based on the company’s
Bond C at 2.84% is lower than the coupon rate.
ability to pay. Credit rating agencies periodically review
their bond ratings and may revise them if conditions or
expectations change.

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the corporate bond contract (called an indenture) often Inflation risk
includes terms called covenants designed to limit credit
Inflation is a general rise in the prices of goods and
risk. For instance, the terms may limit the amount of
services, which causes a decline in purchasing power.
debt the company can take on, or may require it to
With inflation over time, the amount of money received
maintain certain financial ratios. violating the terms
on the bond’s interest and principal payments will purchase
of a bond may constitute a default. the bond trustee
fewer goods and services than before.
monitors the company’s compliance with the terms of its
indenture. the trustee acts on behalf of the bondholders
Liquidity risk
and pursues remedies if the bond covenants
are violated. liquidity is the ability to sell an asset, such as a bond,
for cash when the owner chooses. Bonds that are traded
Interest rate risk frequently and at high volumes may have stronger
liquidity than bonds that trade less frequently. liquidity
As discussed above, the price of a bond will fall if market
risk is the risk that investors seeking to sell their bonds
interest rates rise. this presents investors with interest rate
may not receive a price that reflects the true value of the
risk, which is common to all bonds, even u.s. treasury
bonds (based on the bond’s interest rate and credit-
bonds. A bond’s maturity and coupon rate generally
worthiness of the company). If you own a bond that is
affect its sensitivity to changes in market interest rates.
not traded on an exchange, you may have to go to a
broker when you want to sell it. In addition, the bond
the longer the bond’s maturity, the more time there is
market does not have the same pricing transparency as
for rates to change and, as a result, affect the price of the
the equity market, as the dissemination of pricing
bond. therefore, bonds with longer maturities generally
information is more limited for corporate bonds in
present greater interest rate risk than bonds of similar
comparison to equity securities such as common stock.
credit quality that have shorter maturities. to compen-
sate investors for this interest rate risk, long-term bonds
Call risk
generally offer higher interest rates than short-term
bonds of the same credit quality. the terms of some bonds give the company the right to
buy back the bond before the maturity date. this is
If two bonds offer different coupon rates while all of known as calling the bond, and it represents “call risk” to
their other characteristics are the same, the bond with the bondholders. For example, a bond with a maturity of 10
lower coupon rate will generally be more sensitive to years may have terms allowing the company to call the
changes in market interest rates. For example, imagine bond any time after the first five years. If it calls the bond,
one bond that has a coupon rate of 2% while another the company will pay back the principal (and possibly an
bond has a coupon rate of 4%. All other features of the additional premium depending on when the call occurs).
two bonds—when they mature, their level of credit risk,
and so on—are the same. If market interest rates rise, then one reason the company may call the bond back is if
the price of the bond with the 2% coupon rate will fall market interest rates have fallen relative to the coupon
by a greater percentage than that of the bond with the rate on the bond. that same decline in market interest
4% coupon rate. This makes it particularly important rates would likely make the bond more valuable to bond-
for investors to consider interest rate risk when they holders. thus, what is financially advantageous to the
purchase bonds in a low-interest rate environment. company is likely to be financially disadvantageous to

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the bondholder. Bondholders may be unable to reinvest company issuing the bond, and how the company plans
at a comparable interest rate for the same level of risk. to use the proceeds from the bond sale. similarly, if you
Investors should check the terms of the bond for any are investing in a bond-focused mutual fund or etF,
call provisions or other terms allowing for prepayment. these funds also prepare prospectuses detailing important
information about the fund. Investors can ask their
How can investors reduce their risks? broker-dealer for the prospectus of any bond or bond
Investors can reduce their risks by diversifying their assets. fund in which they are interested. Prospectuses also are
Bonds are one type of asset, along with shares of stock available to the public without charge on the seC’s
(or equity), cash, and other investments. eDGAr website, available at www.sec.gov/edgar/
searchedgar/webusers.htm. You can also find a bond
Investors also can diversify the types of bonds they hold. fund’s prospectus at the bond fund’s website.
For example, investors could buy bonds of different
maturities—balancing short-term, intermediate, and long- Regular periodic reports are filed by both compa-
term bonds—or diversify the mix of their bond holdings nies that have sold bonds in a public offering and by
by combining corporate, treasury, or municipal bonds. bond-focused mutual funds and etFs. Companies that
have sold bonds in a public offering file quarterly reports
Investors with a greater risk tolerance may decide to buy on Form 10-Q and annual reports on Form 10-K,
bonds of lower credit quality, accepting higher risks in among other filings. You can use these reports to learn
pursuit of higher yields. More conservative investors, about and monitor a company’s financial condition.
however, may prefer to limit their bond holdings solely Mutual funds and etFs file annual and semiannual
to high-quality bonds, avoiding riskier or more speculative reports that detail the performance and holdings of the
bonds. fund. these reports are available to the public without
charge on the seC’s eDGAr website. You can also
Instead of holding bonds directly, investors can invest in often find the reports of a bond fund at the bond fund’s
mutual funds or exchange-traded funds (etFs) with a website.
focus on bonds. Investors should base their decisions on
their individual circumstances. Reports on price and trading histories for
particular bonds are available to the public without
How do I research my bond or charge at FInrA’s Market Data Center at www.finra.org/
bond fund investment? Investors/MarketData/P124134.

A prospectus is the offering document filed with the Broker-dealer background checks can help
seC by a company that issues bonds for sale to the investors avoid fraud. You can check the background
public in a registered transaction. Among other things, of broker-dealers on FInrA’s BrokerCheck website at
the prospectus relating to a corporate bond issuance www.finra.org/brokercheck.
describes the terms of the bond, significant risks of
investing in the offering, the financial condition of the

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 Additional Information
For our Investor Bulletin on high-yield bonds, visit For more on bonds in general, visit FInrA’s
sec.gov/investor/alerts/ib_high-yield.pdf. smart Bond Investing at www.finra.org/Investors/
InvestmentChoices/Bonds/smartBondInvesting/
For more information on mutual funds generally, Introduction/.
visit sec.gov/investor/pubs/beginmutual.htm.
For more information about credit rating agencies,
For our Investor Bulletin on etFs, visit sec.gov/ visit our Fast Answer at sec.gov/answers/nrsro.htm
investor/alerts/etfs.pdf. and the website for the seC’s office of Credit
ratings at sec.gov/about/offices/ocr.shtml.
For “using eDGAr - researching Public Compa-
nies,” visit www.investor.gov/researching-managing- For more information about municipal bonds, see
investments/researching-investments/using-edgar- our Investor Bulletin on municipal bonds at sec.
researching-public-companies. gov/investor/alerts/municipalbondsbulletin.pdf, and
visit the Municipal securities rulemaking Board’s
For our Investor Bulletin on reading a Form 10-K, electronic Municipal Market Access (eMMA)
visit sec.gov/investor/pubs/reada10k.pdf. website at www.emma.msrb.org.

For our Investor Bulletin on reading fund reports, For more educational information, visit the seC’s
visit sec.gov/investor/alerts/ib_readmfreport.pdf. website for individual investors at www.investor.gov.

The Office of Investor Education and Advocacy has provided this information as a service to investors.
It is neither a legal interpretation nor a statement of SEC policy. If you have questions concerning the
meaning or application of a particular law or rule, please consult with an attorney who specializes in
securities law.

SEC Pub. No. 149 (6/13)