When corporations and governments need money to finance projects and growth, they can turn to the public to borrow money. Bonds are borrowing contracts. Investors buy them at one rate and are promised a specific amount of return on their principal. In some cases, bonds also come with coupons for collecting interest payments at predetermined intervals. Bond holders are not investors who take ownership in a company, but creditors with first rights to assets if a company or government defaults on its debt. Because companies can fail and go bankrupt, corporate bonds are often considered riskier, but potentially more profitable, than those issued by the U.S. Treasury.
The most attractive aspect of a corporate bond is the yield. Because few corporations have the credibility of the U.S. government, their bonds are considered riskier. After all, corporations can have unexpected changes in their business model, environment and management that can impact their sustainability, whereas the U.S. government continues to operate through good times and bad. To compensate for the added risk, corporations offer higher rates of return on their bonds – often well exceeding that of Treasury bonds and interest rates.
Treasury bonds pay a stable interest rate at a semi-annual frequency during the 30-year term. Some corporate bonds also reward investors with interest payments. In exchange for parting with their money for an extended period of time, companies make periodic, pre-agreed interest payments. While corporate bonds are riskier than treasury bonds, they have the potential to perform better than treasury bonds due to higher interest rates.
Corporate bonds come in many varieties and levels of risk and return. Some traditional, well-capitalized, longstanding blue chip companies offer bonds with AA ratings – almost as high as Treasury bonds. Others have much lower ratings, but can present fantastic returns to an investor willing to take the risk. Those looking for diversified bond portfolios can find significantly more options among corporate bonds.
One of the selling points of corporate bonds is that they usually pay higher interest rates than low-risk Treasury bonds, making them a good option for those seeking strong returns. Furthermore, corporate bond investors can benefit from ratings upgrades on these bonds that can positively affect the interest rate and return on their investments. Treasury bonds can be attractive to those who want to have a guaranteed return on their investment and avoid default risk. The interest earned on Treasury bonds is also tax-free at the local and state levels.