What Is a Corporate Bond, and How Does It Work?

Bonds generally are a form of debt, and corporate bond is not an exception. Whenever an investor purchases a corporate bond, the investor is loaning out the cash equivalent of that bond to the company issuing the bond.

This loan is not interest-free. Instead, the issuing company pays a stipulated percentage of the principal at specific periods during the lifespan of the bond. At the time of maturation, the issuer then pays back in full the principal.

Unlike stocks, dividends from bonds are more reliable and stable because the interest payment is fixed. The investor will therefore be able to say with certainty the time the interest will be paid and the expected amount to be received.

Corporate bonds also are more lucrative than government-issued bonds. Investors should; however, take note that the reliability of corporate bonds is dependent on the issuing company.

What do companies issue corporate bonds?

The reason behind the issuing of corporate bonds is to ensure that companies can raise funds when the need arises without relying on bank loans. Though issuing a corporate bond is not the only way a company can raise money to carry out its activities, it is one of the best ways.

Features of corporate bonds

Corporate bonds have a lot of features that differentiate them from other types of bonds. The information about any corporate bond is contained in the bond prospectus which is made available to intending investors.

Knowing these features and how they influence the security will help to intend investors to know if it will work for them. Some of the features of corporate bonds include:

#1.Maturity date

The lifespan of a corporate bond is spelled out. Investors, therefore, are aware from the onset of the amount of time required for the investment to mature and the initial principal is paid back. What is paid back in the maturity date is the principal and the final interest. The maturity date of a corporate bond can be either short-term, intermediate, or long-term.

See also  How Many Types of Hedging Arrangements? ( Example and Explanation)

The short-term maturity period is one year. The implications of investing in bonds with a short maturity period are many. Short-term bonds are less volatile than long-term bonds. The reason is that the market and business conditions are less likely to experience many changes within that time frame.

#2.Credit rating

The credit rating of a corporate bond is determined by the credit standing of the issuing company. The credit rating of a corporate bond does not only affect the interest that will be paid on such a bond. It also shows the investor the risk involved in buying the bonds and the possibility of default in repayment on the part of the issuer.

When a corporate bond has a high credit rating, it means that the issuer is less likely to default in repaying both the principal and the interest. Investors should therefore choose corporate bonds with a good credit rating.

#3.The possibility of call protection and provisions.

Some corporate bonds are issued with special call provisions and protection. Call provisions make it possible for the issuing company to put out an early call on the bond.

When a bond is called early, what happens is that the issuing company pays back the principal immediately. With the payment of the principal comes an end to the continuous payment of interest.

Call provisions favor issuers and not bondholders. This is because call provisions make it possible for the issuers to stop paying high interest when the conditions in the market improve. Imagine a situation where a company issues a corporate bond with call provisions for 8 years to refinance the business and escape bankruptcy.

If business conditions improve within this period, the company can put out a call on the bond.

On the other hand, call protection ensures that bondholders are paid interest for a specified length of time before the corporate bond is called. The bond prospectus also contains details of the risk involved when a bond is called early or when there is a protection clause attached to it.

See also  What is an Irredeemable Debt? Definition, Explanation, Examples, And More

Benefits of a corporate bond.

Corporate bonds are pretty popular as an investment class. This popularity could result from the underlying benefits that investors are likely to gain from investing in it. Some of these benefits include:

  • Offers relatively high interest: corporate bonds are an excellent way to diversify your cash flow. When placed side by side with municipal bonds, corporate bonds offer a higher interest rate. The investor can accumulate a reasonable sum by holding this security. However, there are also risks associated with corporate bonds, which sometimes are dependent on the company issuing the bond. Investors should therefore take out time to look into the benefits as well as possible risks before investing.
  • A good source of portfolio diversification: every seasoned investor understands that portfolio diversification is a compulsory requirement for building wealth through investment. Corporate bonds, therefore, give investors an extra opportunity to expand their holdings. Bonds generally love in the opposite direction to stocks. This means that when there is a dip in the stock market, bonds are not affected. The interest from one asset class can be used to offset any losses made on another.
  • Bonds offer capital gains: It is possible to speculate with bonds and get higher interest, especially during harsh economic conditions. Corporate bonds are provided by companies in need of finances, making it possible for the price to fluctuate at certain times. Such volatility can bring considerable profits to investors who are ready to make the most of it.
  • Lower risk: Corporate bonds have lower risk levels than some other investment classes, such as stock and other securities in the money market. To minimize the possibility of losing investment in corporate bonds, investors should carefully study the company before making a purchase.

Risks associated with investing in corporate bonds

  • Credit risk: Credit risk uses different factors to analyze the possibilities of a company meeting up with the payment of interest and repayment of principal. A company can run into unfavorable financial conditions that make it impossible to meet up with its charge to bondholders. In such a situation, bondholders may lose the capital invested in the company.
  • Call risk: some of the corporate bonds issued by companies have a provision for calls. This provision makes it possible for companies to call the bonds early and repay the principal before the stipulated time. This call provision does not favor investors, significantly where the price for bonds has increased in the market.
  • Risk of liquidity: selling off corporate bonds can be pretty tricky. This is especially true for bonds that are issued by small firms and companies whose bonds are traded over the counter. Bonds issued by more prominent companies have little or no liquidity issues.
  • Inflation and interest risk: every fixed-interest bond faces the risk of losing value with time. If there is a rise in interest rate, the market value of bonds will fall. Bonds are easily affected by inflation, thereby making the amount accumulated at maturity lower in the matter. Inflation and interest risk increase with time so, long-term bonds face a higher risk than short-term bonds.
See also  What is the Weighted Average Cost of Capital (WACC)? Definition, Formula, and Example

How to purchase corporate bonds

An investor can buy corporate bonds either as individual bonds or bond funds.

  • Individual bonds: corporate bonds are typically issued in blocks. These blocks are available for purchases through different investment platforms, financial service providers, and brokers. Investors can also buy bonds from banks though this comes at a higher fee.
  • Bond fund: bond funds spread the risk and allow investors to gain entry with lower amounts. Investors can get a bond fund either as mutual funds or exchange-traded funds.

Final takeaway

Corporate funds offer investors a steady stream of income, especially when the issuing company has a high credit rating. These bonds also offer higher interest rates when placed side-by-side with government bonds.

If an investor knows how to make a good pick, a corporate bond could offer an excellent way to diversify an investment portfolio.