A corporate bond is a debt instrument issued by a corporation to finance an expansion, a major project or a working capital shortfall. Some corporate bonds are traded on exchanges, but most are dealt with by the dealers in so called over-the-counter markets. Individual investors very rarely own corporate bonds directly, but rather as part of a portfolio held in a mutual fund. Some bonds have a fixed maturity date, while others may be “called” by the issuer at any time.

Traditionally, bonds pay a stream of semi-annual interest payments called coupons, but some don’t pay any interest and the income is earned by the investor in the form of a gain on redemption. Interestingly, such a gain is still treated as interest income rather than capital gain for income tax purposes. This is a very substantial fact, as the tax on this type of income is twice as high as in the case of capital gains on stocks.

Like with any debt in general, corporate bonds can be either secured (asset backed) or unsecured. Unsecured bonds are also known as debentures, and this is what most corporate bonds are even though the word debentures is not used very often. Naturally, unsecured bonds are considered to be a riskier form of investment as compared to secured bonds and, therefore, pay higher interest to the investors. Generally, bonds are considered a safer form of investment than stock. In case of insolvency, bond holders are first in line to receive any money left after the liquidation of the company.

However, there are different levels of safety even among bonds issued by the same corporation depending on whether the bonds represent senior (issued first) or subordinated debt. Bonds issued by smaller companies (also known as junk bonds) are considered riskier than those issued by large, well established corporations. Some bonds have a conversion feature which allows an investor to convert the bond into common stock of the company. Whether you are looking at senior versus subordinated debt, large versus small issuer or secured versus unsecured bond, like with all investments, higher risk means higher potential return as well.

Corporate bonds play an important role in registered portfolios, especially at the retirement stage because they provide high income and that income is not taxable in the registered environment. Bonds are also very important in any balanced portfolio, because they tend to be negatively correlated with stocks and provide stable income making dollar cost averaging possible.

Nikolay Sisan is a Certified Financial Planner and freelance writer in Vancouver.