When companies issue corporate bonds they are borrowing from you, the investor. So when you buy a corporate bond, you are lending money to the company in exchange for an IOU. You become a creditor to the company.
Bonds are an efficient and less expensive way for a corporate to borrow money.
Different types of corporate bonds
Corporate bonds are issued for a fixed term. There are many types of corporate bonds with varying lengths of maturity. Terms can range from two days through to 30 years.
Types of corporate bonds include:
- Corporate commercial paper: these are short-term, unsecured (not backed by any assets) notes issued by corporates generally for raising cash for current transactions; maturities on these notes are typically 30 days but can range from two to 270 days
- Guaranteed bonds: where a company will issue a bond but another company will guarantee to pay if the issuer is unable to
- Income bonds: the principal is promised but interest is only paid when earnings are able to cover the cost
- Speculative or high-yield bonds (informally called junk bonds): companies offering these bonds may not have long track records of sales or earnings or credit strength is questionable; the yields are higher to compensate
- Yankee bonds: these are dollar-denominated bonds issued in the US by foreign companies
- Zero-coupon bonds: this bond does not pay any interest but is issued at a deep discount and will be redeemed at full value
Some bonds also have call provisions, which means that if the company can borrow cheaper elsewhere (or through a new bond) it may call in the bond before the end of its term. These terms are always outlined in the prospectus.
Interest rate or coupon
The company promises to pay interest payments (coupons) while you hold that bond. It pays this interest in regular payments either quarterly, half-yearly or annually.
At maturity (the end of the term), or when a callable bond is called, the sum you invested is returned to you and coupon payments stop.
The interest rate offered on a corporate bond will depend on:
- The perceived stability of a company, with smaller, new or young start-ups, or troubled firms paying more, while established ‘blue-chip’ firms pay less
- Prevailing interest rates and whether they are expected to rise
- The length of the term of the bond, as interest rate fluctuations could reduce the value over time so long-term bonds carry a greater risk.
Yield is what you earn
It’s important to note that investors can sell their bonds before they mature at the prevailing interest rate on the secondary market. The yield is the money the investor earns on their capital. It is standard that when bond prices increase, bond yields fall and vice versa.
An example serves best to illustrate yield.
Par, or face value, is simply the value stated physically on a bond.
So, a bond selling for a par or face value of £1,000 pays a 10% coupon rate. This means every year you, the investor, receive 10% or £100 in interest.
To figure out the annual yield you divide coupon interest by the par value: £100 divided by £1,000, which gives you 10% of the bond’s nominal yield, which is the same as the coupon rate.
Taking the same bond, but let’s assume the investor sells it on the secondary market for £900. The new owner has possession of the bond and will receive the coupon rate of 10%, which is £100 interest paid. However, the yield for the new owner is different.
The interest of £100 is divided by £900, producing a higher yield of 11.1%. If the bond is sold on for a higher price the yield falls but will increase if the price is lower.
If you are building a portfolio of investments then you’ll want corporate bonds to add some stability for three reasons:
- They are considered lower risk than shares
- The interest is generally higher than on gilts (government bonds) or compared with the dividends paid on stocks
- Because the coupon will be paid regularly, you have a predictable income stream
Another advantage is the ability to exit when you like, because corporate bonds can be traded on the secondary market.
Bond prices rise and fall and depending on when you sell, so you can either make a loss or a gain.
From triple A to junk
Your bond is a reflection of the company issuing it. A blue-chip (or investment-grade) company may not offer as high a return as a bond issued by a company deemed below investment grade.
Other terms are low grade, high yield or ‘junk’ [link to junk bond story]. They offer higher rates of interest to compensate for the higher risk that the company may default on its payment.
But a company that had to issue high-yield bonds five years ago could have grown into a respected business with a strong credit rating, and a company perceived as blue-chip five years ago could have gone bust. Reputation alone is not enough.
As a diligent investor you’ll assess the likelihood that a company will be able to return your money at the bond’s maturity.
This involves understanding the company and its fundamentals, determining the level of risk you are comfortable with and becoming familiar with credit ratings.
Researching the company will get you part of the way.
Credit rating agencies
Another good resource is independent credit rating agencies. The big three are Moody’s, Standard & Poor’s and Fitch. They assign credit ratings after assessing a company’s ability to pay back its loans, to make the promised interest payments and the likelihood of default.
A rating agency downgrade or upgrade impacts the yield and therefore the price of the bond. A downgrade, for example, would suggest a deteriorating risk profile of the borrower. The required rate of return on its debt would increase, thereby reducing its price.
Know your risks
As illustrated before, if you want your money back at short notice, don’t put them in corporate bonds because prices may be lower when you want to sell.
Some other risks are:
- Interest rate risk – rising interest rates reduce the value of your bond investment
- Credit/default risk – You could lose it all, the principal and the interest of the corporate bond due to the company defaulting. This is a much more substantial risk for new/struggling companies
- Inflation/purchasing power risk – basically inflation (rising prices) can eat away the buying power of your money in coming years
- Call risk – If you have a callable bond, the issuing company may seize the opportunity, usually as interest rates drop, to call in your bond
- Event risk – risk of certain events such as corporate transactions or natural disasters could cause a downgrade