Corporate Bonds Pros and Cons to Consider Before Investing

By Indeed Editorial Team

Published 4 July 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Corporate bonds are typically part of a company's investment offerings, being allocated to bond subscribers in return for cash. When companies issue bonds, they're referred to as corporate bonds. Understanding these bonds and their purpose can help you better understand how businesses raise capital and manage their finances. In this article, we compare bonds pros and cons, define what a bond is and compare corporate bonds to other types of bonds to help you better understand their purpose.

What is a bond?

A bond is a type of debt- security. Companies and other organisations, like governments, can issue bonds to investors to improve their liquidity. A bond is essentially a promise that the company intends to repay the money the investors provided, often with interest, at a specific date. This is a way for organisations to raise capital for various reasons, such as business expansion, funding operations or paying back shorter-term loans. For governments, selling bonds can be a way to raise capital for infrastructure projects, social safety nets and civil investments. A bond typically has a set price and a maturity date.

Companies usually sell bonds in a denomination like regular cash, such as one bond being $1000. The issuer also sets a specific interest rate for anyone purchasing the bonds, with high-risk bonds often carrying higher interest rates to compensate and attract investors. Lower-risk bonds offer lower returns but may be a safer investment option for investors with lower risk tolerances. Companies issue corporate bonds while governments issue government bonds.

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Corporate bonds' pros and cons

Understanding corporate bonds' pros and cons can help you understand why companies issue them and why investors buy them. While many large corporate entities issue bonds, they have many drawbacks and advantages, depending on how and when the company uses them and the industry the company operates in. Here are some pros and cons of corporate bonds:

Pros

Here are some pros of corporate bonds:

Lower risk returns

One of the primary reasons for buying corporate bonds is the higher guarantee of returns from bonds. Many investors consider bonds much more secure than other traditional investments, such as stocks and options. Many investors buy bonds to diversify and reduce the risk of their portfolios. Companies usually pay interest on their bonds periodically, so investors can expect a relatively stable source of income from them. Because investors can sell bonds in a secondary market, bondholders can capitalise on their investment sooner, such as if they need cash or to respond to market changes.

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Liquidity

Another pro of using corporate bonds is that they provide liquidity for a business. This is equally important for investors, because the more liquidity a business has available to it, the more effectively it can improve its operations and respond to sudden changes. The secondary market for bonds also allows investors to recover some of their investment, even if the issuer can't repay.

Flexibility

Bonds offer investors a lot of flexibility in how they can get a return on their investment. If a bond's value increases in the secondary market, a bondholder can sell it to gain short-term profit. Investors looking for a more stable income can hold the bond until maturity. If a company is unable to repay its debts, bondholders can claim a company's assets to recuperate their investment. The flexibility of bonds also helps reduce their overall risk as an investment.

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Cons

While corporate bonds offer significant advantages for investors, there are also certain drawbacks to consider for both the investor and the issuer. Here are some cons of corporate bonds:

The company can't pay

One of the primary drawbacks of corporate bonds is the credit risk these kinds of investments can carry. When an investor buys a bond, they're risking non-payment from the issuer on both their principal and interest earned if the company defaults or goes out of business. For example, if investors buy bonds in a successful tech company, which suddenly goes out of business before bond maturity, the investors may lose all of their initial investments, including any unpaid interest.

While bondholders can claim a company's assets in these cases, many companies that fail don't have enough assets to repay all bondholders adequately. Some companies may also experience cash flow issues and may delay or reduce interest payments.

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Smaller market

Corporate bonds are often more difficult to purchase for regular investors. Companies usually issue bonds to other large businesses or high-net-worth individuals because of the size of the investments. This means the market for bonds is much smaller than other investment markets, such as stocks. This often means a company issuing bonds may struggle to find enough subscribers. It can also lead to bondholders having difficulties selling their bonds in the secondary market.

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Lower potential for returns

Bonds are typically lower-risk investments, which means they often have a lower potential for returns. Bondholders usually only gain on their investment from the interest paid on their bonds. The longer-term nature of these investments also means the return from these investments takes a long time to accumulate. This may also mean that the value of your returns may decrease over time. For example, if market interest rates increase overall, the value of the interest rate on a bond decreases.

Corporate bonds vs. government bonds

Here are some key differences between corporate bonds and government bonds:

  • Maturity: Many corporate bonds have a lower maturity time than government bonds since they often focus on raising capital to reach short-term goals while government projects often have much longer timelines. For example, building or upgrading large infrastructure may take over 10 years.

  • Volatility: Since corporate bonds depend on the stability of the company and its cash flow, corporate bonds are typically more volatile than government bonds. Governments are often more stable in the long-term, and not as closely dependent on market conditions and other risks that can affect a private business.

  • Taxation: Any interest an investor accrues from corporate bonds is usually subject to taxation. Government bonds are sometimes tax-exempt, allowing investors to earn tax-free income.

  • Risk tolerance: Corporate bonds are more volatile than government bonds, which means they carry more risk for investors. Many investors use government bonds as an alternative to a high-interest savings account because of their stability.

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Corporate bonds vs. stocks

Corporate bonds and stocks are entirely different securities. While a bond is a debt security, where the issuer effectively borrows money from an investor with the promise of repayment at a later date, a stock is a share of a company that the investor owns. For example, if you buy a bond with a large technology company, that company owes you the principal of that bond and any promised interest. A company redeems the bond once they finish repaying. With stocks, you hold shares of the company until you decide to sell your shares.

Stock prices are more subject to market conditions, and rise and fall in response to company changes, news and economic conditions. While bondholders may have priority over stockholders to recuperate their investment if a company goes bankrupt, stockholders have more power over the direction of a company, as they can take part and vote in shareholder meetings. The market for stocks is usually larger than for bonds, so it can be easier to sell them when needed. While some stocks provide regular dividend payments, the majority don't and these payments usually fluctuate.

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