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Any operating business often needs money in order to grow, expand to new locations, upgrade equipment, or any of a thousands other uses of capital. Generally, companies have three choices when they want to raise cash. They can issue shares of stock, they can borrow from the bank, or they can borrow from investors by issuing bonds.
Corporate bonds come in several varieties. Many corporate bonds have a call provision that allows the issuing company to give back the principal to bond holders before maturity.
Other corporate bonds are known as convertibles because they carry a provision that the bond can be converted into shares of common stock under certain circumstances. Convertible bonds can be more attractive than bonds with no conversion provision, depending on the price of the underlying stock.
Most corporate bonds are fixed-rate bonds. The interest rate the corporation pays is fixed until maturity and will never change.
Some corporate bonds employ floating rates to determine the exact interest rate paid to bond holders. The interest rate paid on these bonds changes, depending on some index, like short-term Treasury bills or money markets. These bonds offer protection against increases in interest rates, but the lowdown is that their yields are typically lower than those of fixed-rate securities with the same maturity period.
Other corporate bonds, called zero-coupons, do not make regular interest payments. It's not a trick. These bonds sell at a deep discount to face value, and then are redeemed at the full face value at maturity. The bond holder earns interest on these bonds along the way -- it's all paid back with the principal when the bond ends.
No matter how interest payments are structured, the interest that the company will pay boils down to a single factor -- the rate at which investors believe the bonds are a good investment. When you buy a corporate bond, you must believe that the company will eventually repay you, and make regular interest payments.
Rather than take the company's word for it, you can look at the ratings given by companies that specialize in evaluating corporations and other bond issuers to determine their fiscal strength. Moody's Investors Services and Standard & Poor's Rating Services specialize in assigning ratings to bonds that indicate the ability of their issuers to repay those bonds.
Moody's ratings for long-term bonds:
AAA - Best quality, with smallest degree of risk.
AA - High quality by all standards; together with the AAA group they form what are known as high-grade bonds.
A - Have many favorable investment attributes. Considered as upper-medium-grade.
BAA - Medium-grade obligations (neither highly protected nor poorly secured). Bonds rated BAA and above are termed investment grade.
BA - Have speculative elements; future is not as well-assured. Bonds rated BA and below are considered speculative.
B - Lack characteristics of a desirable investment.
CAA - Bonds of poor standing.
C - Lowest rated class of bonds, with extremely poor prospects of ever reaching any real investment standing.
Corporate bonds generally offer higher yields than municipal bonds for two reasons. First, there is more risk involved with corporate bonds since companies are more likely to run into financial problems than local governments. Second, your earnings from a corporate bond are taxable (compared to the tax-free status of municipal bonds).
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