Companies often borrow money by issuing bonds when they need funds for a new project or for expanding their business. Any purchaser of a corporate bond is merely lending to the company for interest, which is paid at the end of the specified period. It is usually a low risk investment as compared to stocks, though the failure of the company may lead to non-payment.
A company can issue bonds when it is doing well and needs additional money or when it is sinking and it is trying to stay afloat through fresh capital. In the second case, the company may offer a higher rate of interest to attract investors but it will also involve higher risks. However, there is one thing in favor of investors – as they are seen as creditors to the company, they are paid before the shareholders if the company goes bankrupt.
It is always wise to study the financial position of the issuer as your investment risk directly depends on it. While Standard & Poor’s and Moody’s issue credit ratings of companies and also rate bonds, they may not always be correct as the financial crisis showed recently.
Types of bonds
There are two grades of bonds. The first is investment grade, which has low risk but low yield. On the other hand, high yield (or “junk”) bonds have higher risk but higher rates as well. Even within these broad categories, the risk varies from company to company and the time to maturity.
There are some hybrid corporate bonds as well which have emerged recently. One of them is the convertible bond, which can be converted into equity if certain conditions are fulfilled. Callable bonds are those which the company can call and pay before the date of maturity.
Investment in bonds does not lack liquidity, as they are freely tradable in the secondary market. The bond may be sold at a premium or at a discount in the secondary market. When a bond is sold at a price above par, it is called premium and when it is sold at a price below par, it is called discount. Yield at maturity and the credit rating of the issuer will have an important role to play in the price of bond in the secondary market.
If you want to invest in different types of bonds without locking in a lot of your money, you can use exchange-traded funds and mutual funds that make bond investments.