Corporate Bonds

When a company raises capital for its business activities from different individuals and companies

Author: Basil Khalidi
Basil Khalidi
Basil Khalidi
Basil Khalidi, a finance enthusiast, holds a degree in Bachelor's of Commerce (Honors). He has a strong background in equity research and financial modelling. Proficient in conducting comprehensive financial analysis, and sector analysis, and skilled in tools like Excel. Demonstrating proven expertise in crafting impactful articles, and adeptly establishing professional connections. With extensive experience in managing and growing portfolios, Basil has achieved remarkable results in his previous internship. He is adept at leveraging diverse skills to contribute effectively to dynamic teams and projects.
Reviewed By: Parul Gupta
Parul Gupta
Parul Gupta
Working as a Chief Editor, customer support, and content moderator at Wall Street Oasis.
Last Updated:March 12, 2024

What are Corporate Bonds?

Corporate Bonds are a way for companies to raise money for their operations. Instead of giving away ownership, they choose to borrow funds. When a company issues corporate bonds, it's like taking a loan from the public. In simple terms, investors lend money to the company, and in return, the company promises to pay back the loan with interest at specified intervals.

A company creates a document detailing the loan amount and legally commits to repaying it after a set period. Investors who buy these corporate bonds receive interest payments for lending their money. This type of financing is especially common when a company needs long-term capital for activities like expanding the business, buying assets, or investing in research and development.

For example, let's consider Alpha Inc. They decided to raise money by issuing corporate bonds with a 5% annual interest rate and a 10-year maturity period. An investor, Mr. X, decides to invest $100,000 in these bonds. In return, he receives $5,000 in interest every year for 10 years. At the end of the 10th year, he also gets back his initial $100,000 investment along with the final interest payment.

There are also different scenarios to consider, such as the premium issue and discount issue, which we'll explore in more detail later.

Key Takeaways

  • Corporate bonds are a form of debt financing where a company raises funds by issuing bonds to investors.

  • Investors lend money to the company, and in return, they receive fixed interest payments at regular intervals, with the principal amount repaid at maturity.

  • The grade or credit rating of corporate bonds, provided by agencies like Moody's, indicates the risk associated with the bond. Higher-rated bonds (e.g., AAA) generally have lower returns, while lower-rated bonds (e.g., CCC) offer higher returns but come with a higher risk of default.

  • Investors face various risks when investing in corporate bonds, including credit (default) risk, inflation risk, call risk (for callable bonds), interest rate risk, and liquidity risk.

Relationship between Yield and Grade of Corporate Bonds

When it comes to corporate bonds, there's an inverse relation between the grade of a bond and the yield or return it offers. The bonds or debt obligations are given a rating by various credit rating agencies, such as Moody’s, Fitch, etc. Ratings indicate the level of risk for investors. Higher ratings mean lower risk, and vice versa.

For example, Moody’s gives Alpha Inc. a rating of AAA, which specifies minimal risk of default on its loans. On the flip side, Zeta Corp. gets a C rating, indicating a higher risk of loan default. To interpret this type of risk, we need to associate this with the respective returns from the different bonds.

To quote the basic principle:

 “With higher risk comes higher return and vice-versa.”

Let's assume that Alpha Inc. gives a return(or yield) of 4% annually, and Zeta Inc. gives a return of 12% annually. Now, Alpha Inc. has low default risk and hence low returns. On the other hand, Zeta Inc. has a high risk, giving a higher return.

High-grade bonds give a low rate of return, and High-yield bonds involve a higher risk of loan default, but they come with higher returns.

Types of Corporate Bonds

The definition of corporate bonds only includes bonds issued by a corporate body, a government bond issued in a currency other than the home currency, or a supreme international organization (such as World Bank).

The American Bond Market is one of the largest securities markets in the world. Corporate bonds are a crucial and huge part of this market in the US. It not only includes Corporate Bonds but also government bonds and local authority securities.

Bonds can be classified in many ways:

1. Classification based on maturity

  • Short-Term Bonds: They have a maturity period of fewer than 3 years.
  • Medium-Term Bonds: They have a maturity period of more than 3 years and less than 10 years.
  • Long-Term Bonds: They have more than 10 years of maturity.

2. Classification based on credit rating

  • High-Grade Bonds: The bonds with a credit rating of AAA, A, A3, BBB, B, etc., generally give low returns and have a low default rate.
  • Low-Grade Bonds: These are the bonds with high returns/yield and a higher chance of default. They have ratings such as CCC, C, D, etc.

3. Classification based on interest rate

  • Fixed Interest Rate Bonds: These are the types of bonds that pay fixed interest rates at fixed points of time, irrespective of the changes in the market interest rates. The interest rate of the bond is called the coupon rate.
  • Floating Interest Rate Bonds: These are the types of bonds that make coupon payments(i.e., interest payments) in the prevalence of alterations made in the market interest rates. Hence, it fluctuates with the change in the market rate.
  • Zero-Coupon Bonds: When there are no coupon payments on the bonds throughout maturity. The bonds are generally purchased at a discount and are repaid at par on maturity. The difference between the par and discount is the interest payment, paid at maturity.

For example, Alpha Inc. issued zero-coupon bonds at $700; the face value is $1000. On maturity, $1000 will be paid.

$1000 (Total Amount on maturity) = $700(Purchase price which is the discounted price) + $300(Interest paid on maturity)

4. Classification based on backing by assets

  • Secured Bonds: These are the bonds issued directly backed by company assets as collateral. In the event of the company's bankruptcy, to pay off these creditors, the company sells its assets to settle its debt.
  • Unsecured Bonds/Debentures: These are bonds not backed by any company asset. It has two types:
    1. Senior Debentures: If the company defaults on the loan payment, then these debenture holders will have priority of repayment of their capital before Junior Debentures but after Secured Bonds.
    2. Junior Debentures: These debenture holders will be paid at the end after the payment is made to the senior debenture holders.

Risks Associated with Corporate Bonds

Every investment involves risks; whether it is an investment in equity markets, term deposits in a bank account, or corporate bonds, there is a certain amount of risk lingering.

1. Credit (or Default) Risk

As we have already discussed in the above topic, yield vs. grade, a corporate bond with a lower credit rating is more prone to default on the repayment.

A credit of default risk is the risk that a corporation will not make the interest payment or principal repayment timely; hence, it may default on the bonds.

Credit rating agencies play a crucial role in rating bonds based on credit risk. They regularly review the company's financial situation and revise the rating if required.

The bond contract is called indenture, which includes a term to limit the company's credit risk. This term is called a covenant. When the company violates a covenant, the credit rating falls sharply.

2. Inflation Risk

Inflation is the consistent rise in the prices of commodities which reduces individuals' purchasing power. 

The interest payment received by the bonds may not buy a consumer the same amount of goods as it used to buy in previous years. This is due to the decline in purchasing power. 

3. Call Risk

Bonds that the company can redeem before maturity are called callable bonds. Callable bonds have a risk called call risk, in which the company will pay the principal amount(with premium) before maturity and not provide any interest payment.

“One reason the company may call the bond back is if market interest rates have fallen relative to the coupon rate on the bond. 

That same decline in market interest rates would likely make the bond more valuable to bondholders. Thus, what is financially advantageous to the company is likely to be financially disadvantageous to the bondholder.” 

(Source: SEC)

4. Interest Rate Risk

There exists an inverse relationship between the bond price and market interest rates. The longer the maturity, the more the market rates change, changing the bond price.

Hence, longer-maturity bonds provide higher coupon rates than short-term bonds with the same credit ratings to compensate for this.

5. Liquidity Risk

Liquidity is the ability to convert any financial instrument into cash. For example, bonds that are traded at a higher volume rate are more liquid, i.e., they can be sold anytime, as there is a buyer for such bonds in the market.

Liquidity risk may be witnessed when the bond seller cannot seek a buyer for the bond.

Corporate Bonds FAQs

Researched and Authored by Basil Khalidi | LinkedIn

Reviewed and edited by Parul GuptaLinkedIn

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