What Exactly are Corporate Bonds?
You may have heard many investors, brokers, bankers, and professionals liberally mentioning this term on many occasions but have no idea what they really are about. Corporate bonds are yet another instrument that corporations use to generate much-needed cash for their needs.
Normally, a company that wants to expand their operations or maybe infuse capital into a new venture would need substantial amount of money. And often, they would not want to touch what they have in reserve or what they have set aside for the current year’s overhead.
This is where the corporate bonds come into the picture. Companies turn to the corporate bond market to raise money essentially by borrowing them through their corporate bonds. First, the company makes some projections and decides how much they would like to borrow. Next, they would issue a bond offering equivalent to that amount.
Corporate Bonds – Behind The Scene
In simple terms, when you buy a corporate bond, you are effectively lending your money to the company that sold the bonds. Of course, you will have to abide by the terms and conditions that come with the bond offering through an agreement with the company.
Fact: the first important thing that you should know is that corporate bonds are different from equities. When you own a corporate bond, it does not entitle you to become part owner of the issuing company. Instead, you are if effect, a lender to the company. The company will have to pay you a rate of interest over a certain period. And then, they will have to repay you the principal come maturity date – as they specifically mentioned during the time they issued the bond.
You may come into contact with certain corporate bonds that have redemption or call features that affect the fixed maturity date.
However, a corporate bond’s maturity will generally fall into any of these categories:
- Short-term notes (with maturities of not more than five years)
- Medium-term notes (with maturities ranging between five and twelve years)
- Long-term bonds (with maturities longer than twelve years)
Now, if you’re not too concerned about maturity dates, another bond category might interest you. It’s called credit quality. Reputable credit rating agencies such as Moody’s Investors Service or Standard & Poor’s make it their mission to provide independent analysis of corporate bond issuers.
They grade each one of them in relation to their creditworthiness or simply, whether it’s perfectly very safe or quite risky to lend your money to them. As such, you will find that issuers with lower credit ratings will often offer to pay higher interest rates on their corporate bonds. This should be something to consider before investing your money.
How do Corporate Bonds Work?
The bond instrument is technically a loan instrument between the company (that issued the loan) and the investor (who bought the bond). In it, they spell out the terms of the bond where there is an obligation by the issuer to repay the principal (borrowed amount) by the maturity date plus any interests in between. Get it?
The maturity date may be a year or less (short-term), or two to ten years (intermediate-term) and most are from ten to 30 years or even longer (long-term). You may hear the term ‘notes’ also used interchangeably for the bonds but professionally, they denote bonds that will mature in less than 10 years.
Bonds come with a face value (also known as par value) which represents the amount that the issuer will repay at maturity. Corporate issuers usually issue bonds in blocks of $1,000 face values – which means that the investor should expect to receive $1,000 on the bond’s maturity date. There are also baby bonds, or those that have a face value of $500. Let me explain though that even if the face value stands at $1,000, that usually is NOT what you will pay for it in the bond market.
Corporate Bond – Example
Let’s say you purchase a bond with a 6% coupon rate or simply, a 6% bond from XYZ Corporation. Like any common corporate bond, it carries a face value of $1,000. Quite plainly, it means you stand to receive $60 as interest every year (or $1,000 x 0.06).
Many corporations find it better to pay in six-month installments which means, (for this example) you will receive $30 in January and $30 in June. You can find this schedule in the prospectus, the indenture agreement and the bond certificate.
Corporate Bonds Advantages
Investing in corporate bonds give you some distinct advantages such as:
Varied Options For Investors
The good news to an investor is: you have a wider choice of where to invest your money when it comes to corporate bonds. There are so many types in the market that you’re bound to find one or two that really fit your requirements. You can take your pick from short-term bonds that will mature in five years or less or from medium-term bonds with five to 12 years maturity.
If you’re the type who of investor who does not want to keep checking your portfolio all the time, there are long-term bonds that take more than 12 years to mature.
Pick Your Preferred Coupon Structures
Aside from the differing maturities, investors can also pick their preferred coupon structures among many choices. There are bonds that have a zero-coupon rate and by their name, they do not make any regular interest payments.
The government or its agencies and companies mainly issue these bonds but investors make a profit because they can buy them at a discount to their par value.
Zero or Fixed Rate
There are bonds with a fixed coupon rate and these pay a constant interest payment until their maturity date. Investors can find bonds that pay on an annual or semi-annual basis as they prefer.
Floating Coupon Rates
Issuers set the interest rates for bonds with floating coupon rates by benchmarking them against acceptable indices such as the Consumer Price Index (CPI) or the London Interbank Offered Rate (LIBOR). Of course, they would normally add a certain number of basis points (bps) to the benchmark to arrive at the final rate. As the name implies, the interest payments will change correspondingly with the movements of the benchmark.
Step Coupon Rate
Another type of coupon structure is the step coupon rate where the interest payments escalate at predetermined times. This means that the investors will not receive the same amount but an increasing amount at each interest payment date. Majority of these securities carry a call provision which guarantees that the investor will receive the initial interest rate up to the stated call date.
When the bond reaches the call date, the issuer has the option to either call (or pay) the bond or increase the interest rate.
You’re dead right to say that corporate bonds are riskier compared to government bonds, municipal bonds or other types of bonds. But you know that in the world of investment, the riskier instruments often provide a bigger chance for a higher return. It’s the same thing with corporate bonds.
Here’s the kicker: if your bond is from a reputable company, even if the interest rates fall, you can sell the bond in the secondary market and might still realize a decent profit and get cash.
On top of this, you can take your pick based on the different levels of credit risk among different corporate bonds. Well, technically, this credit risk is attributable not to the bond per se, but to the company that issued it. So, you can select what bond you want from the highly creditworthy to the high yielding ones (experts call them “junk”).
When you get lower-quality bonds, you actually introduce greater diversification benefits into your portfolio. This is because the more credit risk there are in a bond, the less it performs – unlike high-quality sovereign bonds like US Treasuries, UK Gilts or German Bunds.
One thing good about corporate bonds is that there is a high amount of certainty about the interest payments you will get at the appointed time. When you take out a loan to purchase something, you will have to regularly pay interest for the loan at certain intervals. This is how the coupon payment structure works – with the parties reversed.
Some companies even give dividend payments and other benefits at their discretion, of course. What it means for you is that you’ll have more certainty about getting a return for your investment.
If you check the secondary market, you will find that many investors and brokers are actively trading corporate bonds. Because of this, investors can have access to their bond’s principal even before their maturity dates. Like other instruments in the market, some bonds can move quicker and you may find that it is more difficult to dispose of bonds that do not trade as often.
Also, because you will be dealing with other investors, you may receive higher or lower than the price you originally paid for your bond. It is a good practice to check the bond’s total issuance and trading history before purchasing it to ensure that it can provide liquidity should you need it.
Corporate Bonds Disadvantages
Investing in bonds can also have the following disadvantages:
Higher Credit Risk
The fact of the matter is, corporate bonds generally get lower credit ratings and of course, higher credit risk vis-a-vis U.S. government bonds. The corporate bonds only carry the guarantee of the companies that issue them. And it all boils down to the credit quality of the issuing company but it runs the whole spectrum: some issuers have a AAA rating but there are also those with a C or lower.
When you buy corporate bonds through brokerage firms, you must take it upon yourself to monitor the risk of such bonds. Your brokers or financial advisors will not and can not do this for you.
However, if you invest in managed portfolios, that is a little better because the asset management firms hire credit experts to monitor each and every security that they own. Another good way to be able to access corporate bonds is by investing in mutual funds.
Normally, a mutual fund will own many hundreds of positions such that they spread out the default risk among them.
Some corporate bonds can become difficult to sell or exchange without drastically reducing their prices. Investors who want to sell these securities are well aware that different variables could affect their transactions. These include the interest rates, the bond’s credit rating and the size of their position.
Chances are that you may not even be able to find interested buyers for your corporate bond on the secondary market. If you happen to be an investor who is in dire need of cash at the moment, this could be a very stressful situation.
Interest Rate Risk
There is an interesting inverse correlation between the bond prices and interest rates. When interest rates fall, the price of bonds in the marketplace generally goes the other way. And conversely, when the interest rates go up, the prices of bonds normally go down.
Here’s the explanation: when interest rates are going down, many investors will try to capture or lock in the highest rates for as long as they possibly can. The technique is to buy every available bond that pay a higher interest rate than the current market rate. This will cause the demand to rise which causes an increase in the bond price.
Reversing the situation, if the current interest rates are going up, investors would naturally dispose the bonds that pay the lower interest rates. This sudden selling would flood the market with bonds, causing the bond prices to go down.
Should You Invest in Corporate Bonds
If you are planning to invest your money in corporate bonds, use this checklist to help you decide if that will be a good move for you.
- When is the bond’s maturity date?
- How many years are the bond’s terms?
- Would you receive interest at a fixed or floating rate?
- In case it is a floating-rate bond, do you have a clear understanding on how to compute for the interest?
- Does the company that issued the bond have the financial capability to pay your interest and return your principal at maturity?
- Do you understand that there’s a real risk that you may lose money if your sell your bonds on the market?
- Are the bonds classified as secured or unsecured?
- Where are you, in terms of payment priority, if the issuing company cannot repay its debts?
- Can the issuer of the bond buy them back from you before the maturity date?