Corporate Bond

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Contributed by: Hira Aziz

 

What is a Corporate Bond? Meaning.

A bonds is a long-term fixed income security. It is a contract between the issuer and the holder of the bond under which the issuer (the borrower) will pay the interests when it will be due and the principal amount on a pre-determined maturity date. A Corporate Bond is a bond issued by a corporation. They are debt obligations or IOUs issued by companies. A bond is a long-term (1 - 30 years) interest-bearing debt security that obligates the issuer to pay the holder interest and repay the principal amount (usually Par Value of $1000) of the loan at maturity. It is a loan in the form of a security. That's why the borrower is called issuer, the lender is called bond holder. The coupons (interest payments) belonging to the bond are usually taxable. Most corporate bonds are fixed-rate bonds. The interest rate the corporation pays is fixed until maturity and never changes.


Why are Companies Issuing Bonds?

Companies use the funds they raise from selling bonds for a variety of purposes, from investing in new facilities to purchasing equipment to expanding the business. Two other main alternatives to acquire these funds is through issuing shares of stock, or borrowing from a bank.


Company Bonds versus Company Stock

Unlike stockholders, bondholders do not own part of the issuing company: they are merely lenders to the issuing company. Bonds normally have a limited lifespan, whereas stocks are indefinite. Bonds are considered to be less risky than stocks since, in the case of bankruptcy, the company has to pay off all its debts (including bonds) before it handles its obligations to stockholders. Furthermore, bond insurance can provide protection for investors against economical loss, in return for paying a specified premium to a third party, usually an insurance company. The premium will provide interest and capital repayments as specified in the bond policy in the event of payment default of the issuer.


Company Bonds versus Government Bonds

Compared to government bonds, corporate bonds generally, but not necessarily, have a higher risk associated with them and offer higher yields. They are typically sold (issued) through underwriting: a syndicate of banks, underwrite the bonds, and sell them on to their customers.


The Market Price of Company Bonds

The market price of a bond is normally the present value of all future interest and principal payments of the bond discounted at the bond's yield, or rate of return. The yield represents the current market interest rate for bonds with similar characteristics. The yield and price of a bond are inversely related so that when market interest rates rise, bond prices generally fall and vice versa.


Types of Bonds

There are a lot of choices available to the investor when it comes to invest in bonds. There are many types of bonds. They differ based on the issuing authority, risk and return, convertibility, redeemability, etc. Here are all main bond types:


Types of Bonds by Issuer: Issuable Bonds

In this category, there are four main types of bonds depending on their issuing authority. Their ownership remains with the issuer.

  • Treasury Bonds: Treasury Bonds are also called "government bonds" because they are issued by the national, federal government. They are often considered as risk-free bonds because it is assumed that such governments will make their promised payments. Therefore, these bonds then do not have default risk. But in fact they are not free from the whole risk because their prices decline when the interest rate rises.
  • Corporate Bonds: Corporate bonds are issued by companies and they are exposed to risk by default because when the issuing company will face a decline in performance and income, it may not be able to pay any interest or the principal payments. This default risk is also called credit risk. The higher the credit risk, the higher the rate of interest will be which the issuer has to pay.
  • Municipal Bonds: Municipal bonds are issued by the state or local government. They are also exposed to default risk just like the corporate bonds. The interest paid on the municipal bonds are exempt from tax in many countries. But they offer a low interest rate as compared to corporate bonds
  • Foreign bonds: These bonds are issued by a foreign government or a foreign corporation. Foreign corporate bonds are exposed to default risk but some foreign government bonds are also risky. Foreign bondholders must face one more risk element if the bond is denominated in a currency other than the investor's own country currency, because a decline in the currency as compared to investor's country currency will cause the investor to lose money.

The bonds issued by the authorities discussed above are issued to the public in a vast variety on the basis of risk, return, redemption, security, convertibility and so on. Some of them are explained in more detail below.


Types of Bonds by Coupon (Interest) Rate

These types of bonds differ based on the basis of their rate of interest and its fluctuation.

  • Fixed Interest Rate Bond: This type of bond is having a fixed coupon rate (interest rate) stated over its face. The issuer normally pays the amount of interest annually or every six months. The coupon rate remains the same during the life cycle of the bond. It is the simplest form of a bond. It is also referred to as a "straight bond" or "bullet bond".
  • Floating Rate Bond: The interest rate of these bonds will vary over time. The interest rate of the bond is normally set for the first six months. After these six months it will be adjusted based on the market rate. Some of them are convertible to a fixed rate debt while others have upper and lower limits for high and low interest rates.
  • Zero Coupon Bond: This type of the bond is issued at a discount (below par value). That is why it does not pay any interest amount to the bondholder. For instance if a bond having a par value $1000 is issued at $700 with zero coupon rate the difference of $300 is the discount availed to the investor. The issuing company will not have any obligation to pay interest but it will pay the full face value of the bond (i.e. $1000) at the date of maturity (for example in 5 years).
  • Original Issue Discount Bond (OID): Like the Zero Coupon Bond this type of bond is also issued at discount (below par value). The difference between Zero Coupon Bond and OID is that OID gives some amount of interest but it is very small and lower than the normal interest rate.
  • Income Bond: This is a type of bond which pays interest only when income is earned by the issuing company. Usually, they are more risky than straight bonds.
  • Indexed Bonds: This is a type of bond whose interest rate is linked with an inflation index (for example: Consumer Price Index). As the inflation rate rises, the interest rate of the bond also rises.

Types of Bonds by Market Interest Rate

The interest rates in the market always change over time, but the coupon interest rate remains the same after the issuance of the bond. Usually, at the time of the issuance of the bond the companies sets the coupon rate as per the market interest rate. Hence they are issued "at par". Following this start, the rise and fall in the going rates of interest will change the value of the bond.

  • Discount Bond: A bond is issued at a discount when the going rate of interest in the market is raised while the coupon rate falls below. Then, the prices of these bonds will be below the par value.
  • Premium Bond: A bond is at premium when the going rate of interest falls below the coupon rate. The prices of this bond will increase and it becomes a premium bond.

Types of Bonds by Convertibility

  • Convertible Bonds: This type of bond has the option available for the bondholder to convert them, under prescribed conditions, into a pre-determined number of common shares of the issuing company. Such convertible bonds have a low coupon rate as compared to non-convertible bonds. They reduce the debt of the company.
  • Bonds with Warrants: A bond issued with a warrant gives a long-term option to the bondholder to buy a stated number of shares at a pre-determined price which gives a capital gain if the price of shares raised. Like convertible bonds they also have a low coupon rate as compared to non-convertible bonds. They do not reduce the debt, but do increase the share capital.
  • Exchangeable Bonds: These bonds also provide the option to exchange them with shares, but they can be exchanged with the shares of another company (ies) in which the issuer company may have a stake.

Types of Bonds by Collateral Security

  • Mortgage Bonds: Mortgage bonds are secured bonds because they are backed by certain assets as a collateral security. The issuer (company) pledges certain assets as security for the bonds. The company can mortgage the assets several times as 1st mortgage bond and 2nd mortgage bond. At the time of liquidation the obligations of 1st mortgage bondholders are given preference over 2nd mortgage bond. Therefore, the 1st mortgage bonds are more secured than 2nd mortgage.
  • Debentures: These are unsecured bonds because they do not have any asset pledged as security for the obligation. Debenture holders are general creditors whose claims are protected by property but not pledged. They are more risky in nature.
  • Subordinated Debentures: These bonds are also unsecured and can be claimed only after payment of senior, higher ranking debt.

Other Types of Bonds

  • Callable Bonds: These are bonds issued with the option of calling them back by the issuing company from the investors at any time before the maturity of the bond. They are called back at the par value. They offer a higher coupon rate than a straight bond.
  • Puttable Bonds: These bonds are issued to the investor with the option of selling them back them to the issuer company before maturity at a pre-determined price. They usually results in a lower coupon rate than a regular bond.
  • Redeemable Bonds: These bonds are issued with specific maturity dates on which the investor will be paid the face value of the bond and the bond is given back to the issuer company.
  • Irredeemable Bonds: These bonds are the opposite of redeemable bonds because they do not have specific maturity dates and terms. They are traded with a defined price but do not have a maturity date. Once an investor purchases such bond he will have to hold it perpetuity.

Types of Bonds by Credit Rating

  • Triple-A and Double-A: The issuer of these bonds has a high creditworthiness according to some rating agency and the bond is considered extremely safe for investment.
  • Investment Grade Bonds: These are the lowest graded bonds, as graded by the rating agencies. These are the bonds that most banks and institutions are permitted to hold by law. They are typically rated at triple-B or higher. They are very risky.
  • Junk Bonds: They are the riskier bonds with a high yield. They are very speculative with double-B and lower ratings. They have a high probability of going into default.

Sources:
Ephraim Matanda (2020), "Modern Financial Investment Management".
"Fundamentals of Financial Management", Brigham & Houston, Tenth edition, 2003.
Sanjay Bulaki Borad (2020), "Bonds and their Types".


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