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    Corporate Bonds Explained

    It's a fact of operating a business -- you often need money in order to grow your business, expand to new locations, upgrade equipment, or any of a thousands other uses of capital. Generally speaking, 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 dozens of varieties. Many corporate bonds feature a call provision that allows the issuing company to pay 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 that 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 use floating rates to determine the exact interest rate paid to bond holders. The interest rate paid on these bonds actually changes, depending on some index, such as short-term Treasury bills or money markets. These bonds do offer protection against increases in interest rates, but the trade-off is that their yields are typically lower than those of fixed-rate securities with the same maturity.

    Other corporate bonds, called zero-coupons, make no regular interest payments at all. No payments at all? Yes, but 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 just that 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 comes down to one factor: at what rate will investors believe the bonds are a good investment. When you buy a corporate bond, you must have faith that the company will eventually repay you, as well as make regular interest payments to you.

    Rather than take the company's word for it, there are companies that specialize in evaluating corporations and other bond issuers to determine their fiscal strength. Moody's Investors Services, Fitch IBCA, and Standard & Poor's Rating Services all specialize in assigning ratings to bonds that determine the ability of their issuers to repay those bonds.

    While all three of these services are available mainly to subscribers, their Web sites can help you to understand how their ratings work, and provide industry analyses and other reports.

    The following are summaries of the definitions of Moody's ratings for long-term bonds.

    • Aaa - Best quality, with smallest degree of investment risk.
    • Aa - High quality by all standards; together with the Aaa group they comprise what are generally known as high-grade bonds.
    • A - Possess many favorable investment attributes. Considered as upper-medium-grade obligations.
    • Baa - Medium-grade obligations (neither highly protected nor poorly secured). Bonds rated Baa and above are considered investment grade.
    • Ba - Have speculative elements; futures are not as well-assured. Bonds rated Ba and below are generally considered speculative.
    • B - Generally lack characteristics of a desirable investment.
    • Caa - Bonds of poor standing.
    • C - Lowest rated class of bonds, with extremely poor prospects of ever attaining any real investment standing.

    Corporate bonds usually offer higher yields than munis for two reasons. First, there is generally 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 muni bonds).