Corporate investment grade bonds

In short

You have probably heard the phrase investment grade and wondered what it actually means for your wallet. I want to sit here with you for a moment and just say plainly that these bonds are not magic, and they are not scary either. A company borrows your money, pays you interest, and returns the principal when the loan is done. That is the whole idea. The rating tells you how likely the company is to keep its promise. Knowing that one thing puts you miles ahead.

The whole of it

What it is

A friend of mine once described a bond as an IOU with a due date written on it. That is close enough to be useful. A corporate investment grade bond is a loan you make to a company, and that company has been judged by a rating agency to be a relatively safe borrower. The rating agencies most people have heard of are Moody's, S and P Global Ratings, and Fitch. Each one looks at the company's finances and stamps it with a grade. Investment grade means the stamp is good enough that the company is considered unlikely to miss a payment. It is not a guarantee. Nothing in finance is.

You lend the company a set amount, called the principal, which is simply the original sum you handed over. While you wait for that loan to end, the company sends you interest payments. Those payments carry an old fashioned nickname, the coupon, and they usually arrive twice a year. When the loan period ends and the bond matures, you receive your principal back. The shape of the whole thing is a patient, predictable exchange, and understanding that shape is most of the battle.

How it works

I once watched a neighbor sell homemade jam at a farmers market, and she figured out fast that people trusted her more if she put a clear label on every jar. Rating agencies do something like that for bonds. S and P and Fitch use letters starting at AAA at the top, then AA, then A, then BBB. BBB is the lowest rung still called investment grade. Moody's uses a slightly different spelling, Aaa, Aa, A, and Baa, but the idea is the same. You can read both systems on the agencies' own websites.

When a company wants to borrow, it files paperwork and pays a bank to help it issue the bond. Investors buy the bond, either when it is first issued or later on the secondary market, which is just a fancy way of saying the place where bonds change hands after the first sale. The price of a bond moves around after it is issued. When interest rates in the wider economy go up, older bonds paying lower rates become less attractive, so their prices fall. When rates go down, older bonds look better and prices rise. Price and yield move in opposite directions. Yield is the return you actually earn based on what you paid.

The numbers, and where to find yours

If you are holding a bond that pays 4 percent and you paid face value for it, your yield is 4 percent. Simple enough. But if you bought that same bond at a discount, meaning you paid less than face value, your yield is a little higher. The calculation that accounts for this is called yield to maturity. It blends your coupon payments with the gain or loss you will see when the bond matures. Brokerage platforms commonly show this number before a purchase is made.

For retirement accounts, the IRS sets limits each year on how much you can contribute to accounts like a traditional IRA, a Roth IRA, or a SEP IRA. Those limits change. Because they change, I will not state a current dollar figure here. The IRS publishes the current limits at irs.gov under its retirement topics pages. That is the only place I trust for a current number. For bonds held inside a taxable account, interest income is generally taxed as ordinary income at the federal level, though your own state rules may differ. Check your state revenue department's site for that piece.

If you are holding bonds in a retirement account, the yearly contribution limit for a traditional IRA is the current figure, which the official source publishes each year. That figure is set by law and shifts by year. A tax professional can explain how it applies to a given situation.

A worked example

Sarah earns $52,000 a year and wants to understand what owning one corporate investment grade bond actually looks like. She finds a bond issued by a large utility company. The bond has a face value of $1,000, a coupon rate of 4 percent, and it matures in 10 years. Because she buys it at face value, her coupon payment each year is $40. That is $1,000 times 0.04. She receives $20 every six months. Over 10 years she collects $400 in interest. At maturity she gets her $1,000 back. Her total return before tax is $1,400 on a $1,000 investment.

Now Sarah buys the same bond but pays $950 on the secondary market because rates have risen slightly since the bond was issued. Her coupon is still $40 a year, because that is fixed. But at maturity she will receive $1,000, which is $50 more than she paid. Her yield to maturity is now a bit above 4 percent. The exact figure requires a more detailed calculation that any brokerage calculator can run in seconds. The point is that paying less than face value boosts her real return.

Sarah holds the bond in a regular taxable account. Her $40 in annual interest is added to her other income and taxed at her ordinary income rate. She did not pick the bond because it was exciting. She picked it because she understood every number before she bought.

Where it goes wrong

I have made my share of costly mistakes, and so has nearly every careful person I know. One easy mistake with investment grade bonds is to assume the rating cannot change. A company can be downgraded after you buy. If it falls below BBB, or Baa in Moody's system, it becomes what people call high yield or junk. Some funds are required by their rules to sell bonds that fall below investment grade, and that selling pressure can push the price down hard. That is called downgrade risk.

Interest rate risk is just as real. Long term bonds feel price swings more than short term ones, because the money is tied up longer. A bond maturing in 2 years will wobble less than one maturing in 20 years when rates move. This is not a flaw in the bond. It is just math.

Liquidity is worth a word too. Liquidity means how easy it is to sell something quickly at a fair price. Big company bonds trade easily. Smaller issues may not. If you need to sell in a hurry, you might take a worse price than you expected.

Questions to answer before you leave this page

Before you move on, I hope you will sit with a few honest questions, because a person who asks good questions saves themselves a lot of grief later, and you deserve that kind of care: Do you know the coupon rate and the maturity date of any bond you are considering, and have you calculated the yield to maturity yourself or confirmed it on your brokerage platform? Do you understand whether you are buying at a premium, meaning above face value, or at a discount, meaning below it, and do you know how that affects your return? Have you checked whether the bond is held in a tax advantaged account or a taxable account, and do you know how interest income is taxed in your state? Do you know the current rating from at least one major agency, and have you thought about what you would do if that rating were lowered? And finally, does the time until this bond matures line up with when you actually need the money back, because that match between your timeline and the bond's maturity is one of the most important things to get right?