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What Are Corporate Bonds And How Do They Work?

Explore how corporate bonds work, valuations, the difference between secured to unsecured and what are the options for bond investors
Author: Baruch Mann (Silvermann)
Baruch Mann (Silvermann)

Writer, Contributor

Experience

Baruch Silvermann is a financial expert, experienced analyst, and founder of The Smart Investor.  Silvermann has contributed to Yahoo Finance and cited as an authoritative source in financial outlets like Forbes, Business Insider, CNBC Select, CNET, Bankrate, Fox Business, The Street, and more.
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Author: Baruch Mann (Silvermann)
Baruch Mann (Silvermann)

Writer, Contributor

Experience

Baruch Silvermann is a financial expert, experienced analyst, and founder of The Smart Investor.  Silvermann has contributed to Yahoo Finance and cited as an authoritative source in financial outlets like Forbes, Business Insider, CNBC Select, CNET, Bankrate, Fox Business, The Street, and more.
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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.

What Happens When You Buy Corporate Bonds?

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.

Corporate Bond’s Maturity Options

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.

While comparing the composition of corporate bond ownership in the United States, non-US investors lead by 27% and 28%, respectively, according to the FED data

 

What is 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.

How Much Interest do Corporate Bonds Pay? 

Corporate bonds do not pay a fixed interest rate, and the annual interest rate may depend on several factors. Generally, the interest rates vary depending on the bond credit rating. A high-rated bond will offer a modest interest rate, while an issuer with a low rating offers a higher interest rate to compensate for high the high risk. 

Also, interest rates depend on the prevailing market conditions. For instance, during economic downturns, the Federal Reserve stimulates the economy by lowering the rates. In return, bond issuers decrease issuing rates.

The interest rates affect the bond value relative to a specific coupon rate. For example, if the coupon rate was 5% on a par value bond of $1000, you’ll receive an interest of $50. However, if the interest rate drops to about 4%, an investor would be willing to pay $1250 for the same coupon rate.?

When Do I Get 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.

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.

Can Bonds be Sold Before Maturity? 

You can sell your bond asset before maturity. However, liquidating your bond prematurely can lead to undesired costs. Some of the factors that can motivate the bondholder to sell the asset before maturity include:

  • Emergency needs-If the holder is in a financial emergency, and the only available money is the cash tied to the bond, he can sell the bond prematurely. Depending on the market conditions, the bondholder can recover the principal amount or sell it at a discount.
  • Speculative reasons– when the bond interest rates drop, investors pay high prices, which is an opportunity to sell your holding at a higher price. However, you will owe taxes on the capital gains.

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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 xtf.com 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.

There was a steady increase in the percentage of households who owned mutual funds, according to data from the Investment Company Institute

 

The Pros & Cons of Corporate Bonds

On the good side, here are the main benefits when investing in corporate bonds:

  • Diversity – When it comes to corporate bonds, the good news is that you have a wider range of options for investing your money. There are so many different types on the market that you're bound to find one or two that perfectly suit your needs. You can choose between short-term bonds that mature in five years or less and medium-term bonds that mature in five to twelve years.
  • Flexibility – Aside from the various maturities, investors can also select their preferred coupon structures from a variety of options. There are bonds with a zero-coupon rate, and as the name implies, they do not make regular interest payments. These bonds are primarily issued by the government or its agencies and companies, but investors profit because they can purchase them at a discount to their par value.
  • Higher Yield Compared to Other Bond Types – You are correct in stating that corporate bonds are riskier than government bonds, municipal bonds, or other types of bonds. However, you are aware that in the world of investing, riskier instruments often provide a greater opportunity for a higher return. The same is true for corporate bonds. The kicker is that if your bond is from a reputable company, even if interest rates fall, you can sell it in the secondary market and still make a decent profit and receive cash.
  • Certainty – There is a high degree of certainty regarding the interest payments you will receive at the appointed time. When you take out a loan to buy something, you must pay interest on the loan at regular intervals. This is how the coupon payment structure works – the parties are reversed.
  • Liquidity – A look at the secondary market reveals that many investors and brokers are actively trading corporate bonds. As a result, investors can access the principal of their bonds before they mature. Some bonds, like other market instruments, can move faster than others, and you may find it more difficult to sell bonds that do not trade as frequently.

On the bad side, there are some risks you should consider:

  • Credit Risk – The truth is that corporate bonds generally receive lower credit ratings and, as a result, carry a higher credit risk than US government bonds. Corporate bonds are only guaranteed by the companies that issue them. And it all comes down to the credit quality of the issuing company, which spans the entire spectrum: some issuers have a AAA rating, while others have a C or lower.
  • Not All Bonds Are Liquid – Some corporate bonds may become difficult to sell or exchange without significantly lowering their value. Investors who wish to sell these securities are well aware that a variety of factors may influence their transactions. These include interest rates, the credit rating of the bond, and the size of their position.
  • Interest Rate Risk – Bond prices and interest rates have an interesting inverse relationship. When interest rates fall, the market price of bonds generally falls in the opposite direction. In the opposite direction, when interest rates rise, bond prices typically fall. In the opposite scenario, if current interest rates rise, investors will naturally sell bonds that pay lower interest rates. The market would be flooded with bonds as a result of this sudden selling, causing bond prices to fall.

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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.

Corporate Bonds vs. Stocks 

Corporate bonds and stocks are both popular types of investments, but they differ in their returns and behavior. Corporate bonds are a type of loan that investors extend to a company or government agency, while a stock represents partial ownership of the company.

Corporate bondholders earn fixed income over time, and get back their full principal amount at the end of the maturity period. Also, the bond value is not affected by the volatility of the stock market. In contrast, stockholders earn a return when their stocks appreciate, and when they sell part or all of their shares of stock in the stock market. Stockholders also earn dividends for each share of stock held in the company.

How are Corporate Bonds Rated?

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

When we talk about the 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.

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 backup but rather the corporation’s good faith and credit.  They also go by the term debenture bonds.  Should the issuing company default 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.

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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.

Callable Vs Puttable Bonds

Callable and putable bonds fall under embedded perks provided by some bonds. They give issuer or bondholder rights to exercise given actions basing on certain conditions.

For callable bonds, the issuer has the right to buy back a part of the bond before maturity. When interest rates are lower, the issuer can redeem the bonds at economical prices, which in return pushes costs downwards. However, to investors, it may be irredeemable on maturity.

Putable Bonds, in contrast, allows the holder to sell the bond to the issuer at a predetermined price on a predetermined date. In comparison to callable bonds, the holder has all the benefits. In this case, when the interest rates increase, the bond loses value. That means the holder can sell back the bond at a lower value and reinvest at a high price, putting the issuer at a disadvantage. 

FAQs

Although corporate bonds are seen as relatively low risk, they can lose value when certain market events occur. For example, when interest rates go up, bond prices go down, and this can result in your bond losing value. Also, corporate bonds can lose value due to inflation.

If the rate of inflation is trending at 6%, and your corporate bond is earning 4.5% annually, it means you are losing value. Other factors that could cause a corporate bond to lose value include restructuring events, credit downgrades, and liquidity-related losses.  

It is improbable that you will lose money in government bonds since the U.S. government guarantees their payment. However, government bonds have lower interest rates in comparison to corporate bonds. To get the full perks of a government bond, you must hold it till maturity.

If you sell the government bond before maturity, you can incur losses. This means the issuer guarantees your principal only when you wait till maturity. Nonetheless, you should know, government bonds interest rates are highly affected by inflation and changes in interest rates.  

Corporate bonds carry a higher risk than other bonds such as government-issued bonds, and they compensate for the added risk by paying a higher rate of return. Some of the factors that make corporate bonds among the riskiest types of bonds include:

  • Credit risk– the issuer may default in paying interests due to bankruptcy or even economic slowdown.
  • Market risk– when the market fluctuates, the corporate could lose value.
  • Interest rate risks– When interest rates rise, the prices of the bonds fall to match the equivalent coupon rate offered before the fluctuation. 
  • Inflation risk: when there is inflation, the rate of return of the corporate bond may fail to outperform the interest rates, leading to tiny returns or reduced principal amount. Therefore, there will be no value in lending your money. 

When you hold your bond to maturity, you will receive the full principal amount. You will also earn interest payments based on the terms of the bond.

For example, if a bond has a face value of $1,000 at a 5% coupon rate and a maturity of 3 years, it means you will receive $50 every year, and the $1000 face value at the end of the maturity period. However, if you decide to sell your bond before maturity, you could sell the bond at a discount (lower value) or at a premium (higher value) of the principal amount.

Since corporate BBB bonds belong to the investment grade category, they are relatively safer than Ba1/BB+ bonds or lower. However, they stand at the dividing line between an investment grade and a non-investment grade.

As a result, a mismanaged investment in a sinking company can result in a downgrade to the non-investment grade, making the bond a riskier investment. However, it may as well mean that the company has been gaining traction, and it is headed to the investment grade category.

An investment grade refers to the credit quality of bonds starting from Baa3/BBB and higher. Investing in bonds in this group is less risky. However, their interest rates are lower. 

In contrast, bonds within Ba1/BB+ and lower are in the non-investment grade. Sometimes they are also known as “junk” grade. If a bond is in the non-investment grade rating, it is in the realm of high risks, and its credibility is not guaranteed. Therefore, the bonds attract high-interest rates than the investment grade as they have to compensate investors for their high level of risk.

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Baruch Mann (Silvermann)

Baruch Mann (Silvermann)

Baruch Silvermann is a financial expert, experienced analyst, and founder of The Smart Investor.  Silvermann has contributed to Yahoo Finance and cited as an authoritative source in financial outlets like Forbes, Business Insider, CNBC Select, CNET, Bankrate, Fox Business, The Street, and more.
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