Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.
Jon has a job with a six figure salary and is interested in investing. He meets with Nickole, a financial planner, and completes a risk tolerance assessment. Risk is a chance of financial loss, and the assessment analyzes Jon's sensitivity to risk. Nickole tallies the results and finds that Jon has a medium to low risk tolerance level. This means he wants to make money from the investment, but doesn't want to lose any.
Nickole suggests Jon begin investing in bonds. Bonds are a contractual arrangement, similar to an IOU, whereby the investor lends money to a company and the company promises to pay it back. There are three main types of bonds: US government, local government, and corporate bonds.
For the rest of this lesson, we will explore corporate bonds and their advantages and disadvantages.
What Are Corporate Bonds?
When a company wants to expand, it has a few options for borrowing money, including seeking a bank loan or selling bonds. Corporate bonds are usually sold in increments of $1,000. The $1,000 is the initial investment and is called the principal.
When investors purchase bonds, they give the corporation $1,000 per bond and the corporation pays the investor annual interest payments. Interest is a fee to paid to the investor to borrow money. When the bond matures, the corporation will pay the investor back their original investment. After Nickole explains corporate bonds, Jon asks, 'What are other advantages besides receiving annual interest payments?'
Nickole tells Jon that one main advantage of corporate bonds is that the company is legally obligated to pay interest and return the principal at maturity. Based on that fact, bonds are low risk.
Since companies are bound by law to pay interest and the principal, there is little chance of the company defaulting on the loan, meaning there is little chance Jon won't receive his money.
Another advantage of investing in bonds is having known earnings projections. Since the amount he will receive is set forth in a contract, Jon knows how much he'll earn annually and the amount he'll receive at maturity (with other investment products, the investor has no guaranteed return on their investment). Jon asks Nickole, 'All the advantages sound great, but are there any disadvantages?'
Nickole explains to Jon that even though corporate bonds have low risk, there is a small chance of default. If a company files for bankruptcy or goes out of business, it would not be able to continue interest payments nor pay the principal back.
Another disadvantage is that bonds are long-term investments. It may take years to receive the principal back, since bond contracts can range from 5 to 30 years. Therefore, investing in bonds won't yield a fast return on your investment.
Lastly, there is a direct correlation between risk and return. Return is the money you receive from investing. Investment products with low risk provide small returns and vice versa. Bonds are considered low risk and have a smaller return compared to other investment products. Nickole explains to Jon that he may be able to invest his money in another product that would pay more than he would receive in bond interest payments. However, those products would have more associated risk.
Bonds are a contractual arrangement, whereby the investor lends money to a company and the company promises to pay it back.
Corporate bonds are sold when companies want to expand and grow and are usually sold in $1,000 increments. The $1,000 is called the 'principal' and the fee the company pays to the investor annually is called 'interest'.
Corporate bonds have many advantages, including contractual arrangements, low risk, and easy-to-project earnings. However, bonds are not without some risk, such as the possibility of default. Another disadvantage is that bonds are a long-term investment and the return on investment is lower compared to other products.
To unlock this lesson you must be a Study.com Member.
Create your account
Register to view this lesson
Unlock Your Education
See for yourself why 30 million people use Study.com
Become a Study.com member and start learning now.Become a Member
Already a member? Log InBack