What is a corporate bond?
– A corporate bond is a debt instrument issued by a company to raise money. When you buy one, you are lending the firm a fixed amount (the principal or par value) and in return the firm promises periodic interest payments (coupons) and to return the principal at a specified future date (maturity).
Key terms (defined on first use)
– Coupon: the periodic interest payment the bond issuer makes to bondholders.
– Par value (face value): the principal amount repaid at maturity (commonly $1,000 per bond).
– Maturity: the date when the issuer returns principal and the bond ends.
– Yield: the return an investor earns on a bond, expressed as a percentage.
– Credit rating: an assessment of an issuer’s ability to meet its payments, provided by rating agencies.
– High-yield (junk) bond: a bond with a lower credit rating and higher default risk, which therefore pays a higher coupon.
– Callable bond: a bond the issuer can repay early under certain conditions.
– Convertible bond: a bond that can be exchanged for shares of the issuing company under predefined terms.
– Income bond: a bond that may not pay coupons unless the issuer has sufficient earnings.
How corporate bonds work — step by step
1. Issuance: A company decides how much capital it needs and hires an underwriter (usually an investment bank) to structure and market the bond offering.
2. Pricing and credit review: Rating agencies may evaluate the issuer’s creditworthiness; the rating helps set the coupon rate investors will demand.
3. Sale to investors: Bonds are sold in standard denominations (typically $1,000). The issuer receives cash; investors receive the bond contract.
4. Coupon payments: The issuer pays interest at the agreed schedule (most commonly semiannually, though some pay monthly or quarterly).
5. Trading: Bonds can be held to maturity or sold earlier in the secondary market. Market prices fluctuate with interest rates, credit quality, and liquidity.
6. Maturity or call: At maturity the issuer repays principal. If the bond is callable, the issuer may repay early under specified conditions.
Why companies issue bonds
– Raise capital without diluting ownership. Debt preserves equity control.
– Often cheaper than issuing new stock because interest is tax-deductible for corporations.
– Provide funding for specific projects, acquisitions, or general working capital needs.
– Short-term funding needs are sometimes met with commercial paper (typically maturing within 270 days).
Assessing value and risk
– Credit risk: The chance the issuer cannot make interest or principal payments. Credit ratings (from agencies such as Standard & Poor’s, Moody’s, and Fitch) summarize this risk.
– Interest-rate risk: Bond prices move inversely to market interest rates. When rates rise, existing bonds with lower coupons typically fall in price.
– Liquidity risk: Some corporate bonds trade infrequently; selling before maturity can be costly or difficult.
– Call risk: If a bond is callable, the issuer may repay when rates fall, limiting upside for investors.
– Seniority: In bankruptcy, bondholders (creditors) rank ahead of shareholders when assets are distributed.
Ratings and their impact
– Higher-rated bonds (investment grade, e.g., AAA, AA, A, BBB under S&P’s terminology) imply lower default risk and thus lower coupons.
– Lower-rated bonds (below investment grade, often called high-yield or junk) pay higher coupons to compensate investors for elevated default risk.
– Ratings affect demand and pricing: better ratings generally mean lower yields and higher marketability.
Common features and varieties
– Fixed-rate vs. floating-rate: Fixed pays a set coupon; floating adjusts with a reference rate.
– Callable: issuer can redeem early, typically at a premium.
– Convertible: allows conversion to equity under specified terms.
– Income bonds: typically issued by distressed companies and may not pay coupons unless conditions are met.
Corporate bonds vs. stocks
– Bondholders are lenders; shareholders are owners. Lenders receive interest; owners receive dividends only if declared and share in company upside.
– In insolvency, bondholders have priority over shareholders for repayment.
– Bonds typically offer more stable income; stocks offer upside potential and higher long-term volatility.
Corporate bonds vs. Treasury bonds
– U.S. Treasury securities are backed by the federal government and carry lower default risk; therefore Treasuries usually pay lower yields.
– Corporate bonds compensate for higher issuer default risk with higher coupons.
Payment frequency and insurance
– Most corporate bonds pay interest semiannually (every six months), but monthly or quarterly schedules exist.
– Corporate bonds are not FDIC insured. They are subject to issuer credit risk.
How to buy corporate bonds
– Directly through broker-dealers in the secondary market or during new issues via underwriting syndicates.
– Indirectly via bond mutual funds or exchange-traded funds (ETFs) focused on corporate credit, which offer diversification and professional management but charge fees.
Short checklist before buying a corporate bond
– Check the issuer’s credit rating and recent changes.
– Compare coupon and yield to similar-maturity Treasuries (credit spread).
– Confirm maturity date and whether the bond is callable or convertible.
– Review payment frequency and any special covenants or protections.
– Assess liquidity — how often the bond trades and typical bid-ask spreads.
– Consider tax implications and where the bond fits in your portfolio (income needs, time horizon, diversification).
– Account for transaction costs and any fund management fees if buying ETFs or mutual funds.
Worked numeric example (price effect from a rate rise)
Assumption: You hold a 5-year corporate bond with par value $1,000, fixed coupon 5% paid semiannually. That means you receive $50 per year or $25 every six months. Suppose market yields rise to 6% annually (3% per half-year). What is the bond’s