What is a Cooperation?
A cooperation is a large entity that is publicly traded. Think Coke, Pepsi, Wal-Mart, Apple etc. I somewhat went over this in the accounting section but this is an important distinction because there are many different types of bonds available to investors and traders; however, I would say that cooperate bonds are the highest interest yielding out of the bonds I will talk about which comes with pros and cons depending on your overall tax bracket. What I mean by this is even the AAA rated bonds will pay higher interest rates than T-Bills or municipal bonds.
Why do corporations issue bonds?
You might be asking yourself why don’t cooperation just go to the bank like everyone else or only issue sock? The first point that I would like to bring up is that some of these companies are huge in size. It would be too risky for one bank to lend them all the money they need. Think about the size of some of the business I have mentioned. They are huge in size and need large amounts of operating capital and investment capital to fund themselves. What you are actually doing as an investor is lending the cooperation money for growth or to stay liquid which is important to our economy.
The next thing you might be wondering is why cooperations don’t just sell a bunch of stock to fund their operations? One benefit is the tax deduction that companies get from paying interest. It is a deduction on the IRS from 1120 as an expense which benefits the company. On the other hand, they can’t write off dividends paid to shareholders.
Another important thing to understand about common stock shares is that it loses value when a company issues more of them. The way Wall Street calculates the value of the stock is called the price-earnings and earnings per share. The more stock they issue the more the already outstanding shares gets devalued.
How do Cooperate Bonds Work?
In the main bond section of this, I talked about a few important generalisations of bonds. One thing that is important to investors is the bond rating which I go over on this page. I will introduce some new things about cooperate bonds that are important to understand before you make an investment.
Unlike other investment types, bonds have a $1000 par value. What this means to you as an investor is that it doesn’t matter how much you pay for the bond. It will always be worth the $1,000 par value at the end of its life. Along with this, I will talk about bond discounts and premiums
- A bond discount is when you pay less than $1,000 per bond.
- A bond premium is when you pay more than $1,000 per bond.
The reason why these two terms are important is bonds are rarely ever sold at $1,000 because they there are so many factors that influence their price. This is a subject all on its own and I will write more about how valuation works.
The coupon isn’t a literal coupon anymore. Years ago, bond investors had to cut coupons off and send them in to receive the interest payment. Most bonds pay semiannual interest, so the coupon will be 6 months of interest.
No Coupon Bonds
This is another class of bonds that an investor can buy. Some of these are called zero interest bonds which have a deceiving name. The company will issue these bonds at less than par or face value. They don’t pay coupons but you do make interest when you sell the bond or it expires.
One last type of cooperate bond that you should be familiar with is the convertible bond. These are a unique type of bond that allows the cooperation to sell them for more money during an IPO. What convertible can mean id that the bond holders can trade their bonds in for shares of stock. This gives investors an incentive to buy the bond and possibly become shareholders. It is an interesting animal all on its own.
The Negatives of Buying Cooperate Bonds
From an investor’s perspective, cooperate bonds aren’t my favorite. Cooperate bonds are taxed like your ordinary income. This is only negative if you are in a high tax bracket. Let’s say that you are in a high tax bracket upwards of 25%. This means that you will pay 25% on those earnings from bond interest. If you were to receive dividend income, you won’t pay more than 15% in tax.
If you buy a cooperate bond will it outperform the companies common stock? That is one thing that investors try to predict and one reason why I believe cooperations issue convertible bonds. Bond’s might be a safer choice but they don’t offer the growth opportunities of other investments. This is a suitability issue depending on what type of investment you need.
Interest Rate Risk
The last risk that I want to talk about is the market rate fluctuations especially since we are in a low-interest environment. One risk that comes along with a cooperate bond is rising interest rates and losing principal on your investment. Right now if you have a bond that pays 5% then try to sell it when the market rate is 8% your bond will be worth less money.
Ask yourself if you would pay full price for a 5% bond when you can get one for the same price yielding 8% interest? What happens is the bond is discounted in price so that the yield to maturity is 8%. So as an example the 5% bond will sell at a discounted rate of $900 per bond and the 8% will sell at the full $1,000. (Not factual. Just a demonstration.)