Any bond is a debt obligation. A bond is also an alternative source of finance. To define a corporate bond, it is a debt obligation issued by a corporation or business to raise funds. Corporate bonds are used for financing ongoing operations, M&A and business expansion.
Corporate Bonds VS Stocks
Buying a stock means owning equity in the business where the investors receive dividends declared and paid by the company.
Buying corporate bonds simply means providing a loan to the company. Bonds do not provide the ownership. In return, investors receive the interest and principal on the bonds. Investors receive the interest no matter how much they earn profit or how low the share value of the stock of the company falls.
Features or Characteristics of Corporate Bonds
- Corporate bonds are debt forms of investment.
- Bonds have a fixed maturity date.
- Repayment of principal amount is done after the maturity date.
- Bonds have a fixed period coupon rate or coupon payment. Some bonds are zero coupon bonds which are sold at discount and redeemed at par.
- Most of the corporate bonds trade in the secondary market.
- A corporate bond has a lower associated risk.
- Investment in corporate bonds is taxable. Corporate bonds are taxed first in interest earned and even in capital gains or losses during sale of the bonds.
Risk associated with Corporate Bonds
Credit risk means default risk i.e. this risk shows the possibilities of company defaulting. A bond default is the situation when the issuer of the bond fails to make interest or principal payments within the specified period.
Triggers for Credit Risk:
- Internal dysfunction of the company
- Fragile economic situation
- Regulatory changes
Some corporate bonds have “call provision” i.e. the issuer of the bonds has the right to retire the debt prior the scheduled maturity date. Early redemption of corporate bonds may have potential loss in investment return.
In early calls, the principal amount and interest are returned to the investor much before the maturity date. For this, the issuer has to pay a premium in addition to the coupon rate to call the corporate bond.
Corporate bonds have a relatively thin market i.e. investors might not be able to sell their bonds like any other liquid assets. The buying and selling propensity of corporate bonds is low. The secondary market for such bonds is very illiquid and the price factor is less efficient. Liquidity of the corporate bonds affects the realized return in bond investment.
Interest Rate Risk
This risk relates the interest rate with the value of the investment in the bonds. When there are unexpected fluctuations in the interest rates, the value of the bond investment also fluctuates. When the interest rate in the market rises, the value of bond investment declines, as the new bonds will offer higher yield.
If interest rate increases, the demand and supply of existing bonds in the secondary market also decreases as demand for new bonds increases with higher yield.
Inflation decreases the purchasing power of every individual. Similarly, inflation affects the value of bondholder’s investment and coupon interest payment. Bonds are issued as a long term financing option hence, such longer maturity increases the risk of inflation in the bond.
Advantages of Corporate Bonds
- Corporate bonds are less volatile than equity (stocks) investment. There is fixed coupon payment and businesses have the obligation towards the principal amount.
- In normal conditions, corporate bonds are often liquid. This means, it is convenient to trade the bonds without affecting the price of the bonds.
- Bond investors enjoy the legal protection. In case of any default or bankruptcy, bondholders may receive some money back.
- Corporate bonds are used for diversifying portfolios. Investors can reduce the net volatility in the investment by investing in bonds.
- Bonds have a fixed income stream and structured payment schedule.
- The pricing of bonds are generally stable and show less fluctuations unlike the price of the stocks.
- Some of the bonds are callable and some bonds are convertible. Such feature bonds make bonds more likable.
- There are different bond structures i.e. a bond can have different maturity periods> based on the purpose of financing.
Disadvantages of Corporate Bonds
- Corporate Bonds generally have higher credit risk than government bonds. Rating agencies rate bonds and it reflects the credibility.
- Secondary market for bonds is not as accessible as the secondary market for stocks/shares. This makes bonds comparatively less liquid form of investment.
- Bond market is greatly affected by the inflation and interest rate. Fluctuation in interest and inflation rate, affects the interest earned and real investment value of the bonds. This may discourage the investors in the short run.
- Fixed payment of bonds is good for passive investors but the same fixed payment bonds yield comparatively less during better economic conditions. This may be the opportunity cost for many speculators and active investors.
- Corporate bonds do not have or have low chances of capital appreciation. Nobody expects to earn from bond appreciation.
- Bond ratings impact the corporate bonds heavily
Types of Corporate Bonds
Junk Corporate Bonds
The corporate bonds issued by financially struggling companies are termed as junk bonds. Junk bonds carry higher risk of default, therefore junk corporate bonds investment have higher return. Generally, bonds with Baa or BBB and lower ratings are categorized as junk bonds.
Investment Grade Bonds
These are the bonds with ratings higher than BBB and can go up to the highest rating of AAA. Such bonds are issued by companies with strong fundamentals and position. Generally, it is evident that such corporate bonds have less or no chance of payment default.
Fixed Rate Bonds
In this corporate bond, bondholders get a predetermined amount as interest. The coupon interest, maturity or tenure of corporate bonds remain fixed in this type of bonds. Such bonds are also called vanilla bonds.
Floatation bonds are those corporate bonds whose interest rate is adjusted periodically as per the market conditions. Repo rate and reverse repo rate can stand as benchmarks for floating rate bonds.
Such bonds are hybrid bonds. In these bonds, bondholders have the option of converting the bonds into stocks. Such bonds once converted into shares do not have any obligation of interest afterward.
Zero Coupon Bonds
Such bonds do not have any coupon payment. Such corporate bonds are available at discount. The principal amount is paid during the maturity. Such bonds are a perfect choice for those who prefer long-term investment.