When you buy shares of stock, you own a piece of a company; when you buy corporate bonds (or corporates, as they're also known), you are lending the company money for a specified amount of time and at a specific rate of interest. While corporate bonds are more risky than government or municipal bonds, long-term corporate bonds have outperformed their government and municipal counterparts over the past fifty years.

Unlike the U.S. government, however, companies can — and do — go bankrupt, which can turn your bond certificates into wallpaper. K-mart, United Airlines, and Enron are all examples of large companies that have declared bankruptcy in recent years. Therefore, the risk of default comes into play with corporate bonds. The rating system, described in Chapter 7, will guide you to the more secure bonds issued by the more stable companies.

Corporates are generally issued in multiples of either $1,000 or $5,000. While your money is put to use for anything from new office facilities to new technology and equipment, you are paid interest annually or semiannually. Corporate bonds pay higher yields at maturity than various other bonds — though the income you receive is taxable at both the federal and state level.

If you plan to hold onto the bond until it reaches maturity and you are receiving a good rate of return for doing so, you should not worry about selling in the secondary market. The only ways in which you will not see your principal returned upon maturity is if the bond is called, has a sinking-fund provision, or the company defaults.

Bond Calls

A call will redeem the bonds before their stated maturity. This usually occurs when the issuer wants to issue a new bond series at a lower interest rate. A bond that can be called will have what is known as a call provision, stating exactly when the issuer can call in their bond if they so choose. A fifteen-year bond might stipulate that it can be called after eight years. Reinvesting in a bond that has been called will usually involve lower rates. Since the call will change the mathematics, your yield to maturity won't be the same.

Sinking-Fund Provision

A sinking-fund provision means that earnings within the company are being used to retire a certain number of bonds annually. The bond provisions will indicate clearly that they have such a feature. Each year enough cash is available, a portion of the bonds will be retired, which are usually chosen by lottery. Whether the bonds you're holding are selected is merely the luck of the draw. Unlike a call provision, you may not see anything above the face value when the issuer retires the bond. On the other hand, since the company uses money to repay debts, these bonds likely won't default, making them a lower-risk investment.

There are a few other reasons why bonds can be called early, and those are written into the bond provisions when you purchase them. As is the case when you buy any investment, you need to read everything carefully when buying bonds. There are numerous possibilities when it comes to bonds and bond provisions. Again, read all bond provisions very carefully before purchasing.