Corporate Bonds Basics – How Do They Work?

Over the years, the need for companies to come up with cash to fund their projects, expansions or new ventures has created many financial products that are now common in the market.In this article, we explain how do they work, valuations of bonds, secured vs unsecured bonds and what are your optins if you would like to invest in corporate bonds
Corporate Bonds Basics - How Do They Work

What are Corporate Bonds?

Companies have many ways to raise funds aside from their normal income streams.  Over the years, the need for companies to come up with cash to fund their projects, expansions or new ventures has created many financial products that are now common in the market.

Similarly, these products are tools that allow these companies to borrow money from people.  One such popular product is the corporate bond.  When the company already knows how much it needs, it can issue a bond offering equivalent to that amount.  When you buy their bond, you are in effect, lending your money to them.  You will find the specific terms and conditions in their bond offer or prospectus.

Sounds simple enough, right?

There’s a lot more to these bonds than meets the eye.  For starters, buying a company’s bond does not make you a part owner of that company.  Equities will have that effect, bonds will not. Since the company is technically borrowing from you, they will pay you interest over a period of time and repay you the principal at the maturity date.  This date has been pre-determined by the bond’s issuer when they issue the bond.

Most bonds will fall under these three simple categories according to their maturity ranges:

  • Short-term notes are bonds with maturity dates of up to five years after their issue date.
  • Medium-term notes are bonds with maturity dates ranging between 5 and 12 years after their date of issue.
  • Long-term bonds are bonds with maturities greater than 12 years.

Note that some corporate bonds might have redemption or call features that can influence the maturity date.

Aside from their maturity date, you can classify bonds according to their credit quality.  There are reliable and independent credit rating agencies that analyze and rate these corporate bonds.

Moody’s Investors Service and Standard & Poor provide a rating of the corporate bond issuers, giving them certain grades with respect to their creditworthiness.  You might find that the companies with the lower credit ratings normally offer higher interest rates on their bonds to counter any unpopularity their low rating might create.

Bond Face Value

You might encounter the term face value when inquiring about bonds.  It simply represents that amount that the issuer will pay the bondholder when the bond reaches its maturity date.  Sometimes, bankers call it the par value.

Normally, bond issuers issue their bonds in $1,000 denominations which means that if you are a bond investor, you should expect to receive $1,000 on your bond’s maturity date.  Some issuers issue baby bonds with a face value of $500.  We’ll tell you what though:  the bond’s face value is often not the market price of the bond – sometimes, you have to pay more for them upon purchase.

Bond Payments

You should take note of the normal practice when it comes to bond payments.  You have to wait until the bond’s maturity date to be able to receive your money back from the issuer.  However, you will receive a specific amount representing the bond’s interest regularly – most often on a semiannual basis.

Now, in case you are able to buy a serial bond, there will be specific principal amounts that will become due on specified dates.  When you buy a bond, it will already specify the interest rate (or coupon rate) as a percentage of its face value.  The issuer normally quotes this on an annual basis and it does not change or fluctuate for the entire life of the bond.

Corporate Bonds – Example

For instance, let’s say you buy a bond with a 6% coupon rate from Company AAA with a face value of $1,000.  This will prospectively make you receive $60 in interest payment every year (or 6% of $1,000).

However, most issuers pay interest in 6-month installments so that if they pay the first $30 in January, the next $30 would be payable in June.  You just have to look at the bond’s prospectus, indenture agreement, or the bond certificate itself to see the payment schedule.

Secured Vs Unsecured Bonds

A bond is a debt instrument by a corporation and like any other corporate debt, it can be Secured or Unsecured.

Secured Bonds

Simply put, they are secured bonds because the issuing corporation is using their own assets to back the bonds as a guarantee.  In case the corporation becomes bankrupt, a trustee will take possession of the company’s assets and liquidate them.  The trustee will then make sure that the bondholders get their principal accordingly.

If the corporation somehow fails to pay its bondholders, the bondholders will get their payment out of the proceeds of the sale of the company assets.  This is because the company used its assets to secure the company’s obligation to the bondholders.

Unsecured Bonds

Unsecured bonds do not have the issuer’s specific tangible assets as their back up but rather by the corporation’s good faith and credit.  They also go by the term debenture bonds.  Should the issuing company defaults on its bond obligations, the bondholders would have the same claim and priority on the company’s assets as any other general creditor.

In the hierarchy of settling its obligations, the company would pay the secured bondholders ahead.  The good news is, the debenture bondholders will receive their money ahead of the stockholders.

What’s Happen in Case of Bankruptcy?

A bond is a debt of the company that issued it, it’s that simple.  Therefore, the company has an obligation to repay it and, in this case, with interest as agreed upon.  Now, just in case the company goes under and files for federal bankruptcy protection, the liquidators will pay the creditors ahead of the owners.

So, in this case, the bondholders have more chance of getting their money than the stockholders.  Of course, the process will follow the bankruptcy laws when it comes to repayment priorities but the stockholders, being the owner of the company, will have the last shot on the assets.

When a company files for a ‘Chapter 7’ bankruptcy, bondholders would receive a portion of the value of their bonds from the company.

Once they receive notice of the bankruptcy filing, bondholders must file a claim against the company.  This will allow them to receive a payment from the company if there are still funds on hand after the administrators have settled the other expenses.  You can go to the website of the Administrative Office US Courts to download a proof of claim form.

Default happens when a company or a corporation is not able to pay the principal and interest on their loans when they become due.  Following a corporate bankruptcy or liquidation, secured creditors, bondholders, and holders of senior debt issues get a higher priority in repayment.

However, in many cases, these entities do not get sufficient repayment to get all their money back.  Another bad thing is that the bonds of companies in default are most likely to trade at very low prices and realistically, there is hardly any party who would show interest to trade them.  In such case, liquidity will most certainly disappear.

Chapter 11 Vs Chapter 7

A company may file for a Chapter 11 bankruptcy and, unlike in Chapter 7, it can get a second chance at life.  The company will continue to operate and will have to undertake drastic measures to save it from totally sinking.

As a result, its bonds may continue to trade but the bondholders will not receive the interests and principal.

In other words, the company will default on the bonds.  As an effect, the value of the securities would likely fall steeply and trading would most likely be extremely constrained.

It could also happen that part of the court-approved reorganization plan, the company might issue new stock, new bonds, or a combination of new stocks and bonds in exchange for their bonds.

Just remember to note that the new securities could not be worth the same as the bonds – they would probably be worth less.

How are Corporate Bonds Rated?

Two lines set bonds apart from each other – investment-grade and speculative-grade.

When we talk about credit perspective, there are two major classifications that distinguish bonds from each other.  These are whether they are investment-grade or speculative-grade.  Speculative-grade bonds come from companies that get a lower level of credit quality.  Investment-grade bonds originate from companies that are highly-rated, credit-wise.  There are four rating grades for investment-grade category and six rating grades for the speculative-grade bonds.

Originally, there were three types of companies whose bonds fell under the description of ‘speculative-grade’.  These were new companies, or those in a highly competitive or volatile industry, or had unstable fundamentals.  But today, many businesses choose to operate with a degree of leverage that somehow defines them in the same league as speculative-grade companies.

Here’s the deal:  speculative-grade credit rating normally accompanies corporations with a higher default tendency.  Normally, these higher risk companies offer higher interest rates or yields.  The good thing is, credit ratings are not set in stone.  A company’s credit rating can go up if their fundamentals improve.  On the other hand, they can also downgrade the ratings if the credit quality of the issuer deteriorates.

Corporate Bonds Investment Options

Valuing Corporate Bonds

Is there a magic formula that investors use to evaluate corporate bonds?  Basically, they just look at their yield advantage (otherwise known as “yield spread”) when placed side-by-side with U.S. Treasuries.  They use Treasuries as the benchmark because investors consider them as ‘completely free of default risk’ among all the other instruments in the market.

This is why when you find highly-rated companies such as Microsoft, Exxon, Apple, etc. who have enormous cash balances on their financial statements, they would often offer lower interest.  However, investors confidently buy them because they know that these companies will not likely default on their obligations and will pay interest and principal on time.

On the other side, companies with higher debt, low liquidity or unreliable income streams usually get a lower rating.  These companies often need to jack up their interest offers a little bit for their bonds to make them more attractive to investors.

You see, if you are an investor, the picture is pretty clear and simple.  It’s your choice between a bond that has lower risk but lower yield or one that has higher risk but higher yield.  But here’s an interesting fact:  from the period 1996 through 2012, investment-grade corporate bonds yielded an average 1.67 percentage points higher than U.S. Treasuries.

What are the options when it comes to bond maturity?

In their most simple category, you can have your pick between short-term, intermediate-term and long-term corporate bonds.

Aside from the fact that they mature much earlier, short-term bonds usually have lower yields.  This rides on the idea that the risk is lower than the issuer would fold up or default in a three-year period.  Obviously, a 30-year bond exposes the investor to a longer period of uncertainty because a lot more things could happen to the issuer within that time frame.  Naturally, long-term bonds offer higher yield but one should not overlook the reality that they tend to be more volatile.

If you are getting the services of an investment manager, make sure that he is familiar with this aspect of investing.  A good one will add value to your portfolio by combining bonds of varying maturities, yields, and credit ratings so that your investment can achieve the best mix of risk and of course, return.

How to Invest in Corporate Bonds

If you are seriously considering investing in corporate bonds, there are basically two ways to do it.

The first way is by purchasing individual corporate bonds through your broker.  If you want to go through this route, you should at least do some research beforehand.  Try to get all the information you can get about the issuing company particularly their financials and underlying fundamentals.  Just make sure that the company that issues the bonds are not at risk for default.  Another thing to remember is that you should diversify your portfolio by purchasing bonds of different companies representing different industry sectors and varying maturities.

The second route is by investing in mutual funds or exchange-traded funds (ETFs) that specialize in corporate bonds.  Of course, funds have another set of risks apart from the bonds themselves but they do have the benefit of high diversification and access to professional managers.  You may use tools such as Morningstar or if you want to compare funds and mutual funds, respectively.  You may also choose to invest in funds that focus exclusively on corporate bonds whose issuers are in the developed international markets and the emerging markets.

A word of caution though:  they have higher risks that their U.S. counterparts but yield-wise, they have the potential to provide you with much higher returns in the long term.