A corporate bond is a debt security issued by a corporation and sold to investors. The backing for the bond is usually the payment ability of the company, which is typically money to be earned from future operations. In some cases, the company’s physical assets may be used as collateral for bonds.
Corporate bonds are considered to have higher risk than government bonds. As a result, interest rates are almost always higher on corporate bonds, even for companies with top-flight credit quality. For example, as of 2016, 5-year U.S. Treasury bonds yield just over 1.08% on average, while the average yield on five-year corporate bonds is 1.57 for AA bonds and 1.79 for A bonds.
How Corporate Bonds Work
Corporate bonds are issued in blocks of $1,000 in par value, and almost all have a standard coupon payment structure. As the investor owns the bond, he receives interest from the issuer until the bond matures. At that point, the investor can reclaim the face value of the bond. Corporate bonds may also have call provisions to allow for early prepayment if prevailing rates change, and investors may also opt to sell bonds before they mature.
The least expensive bonds from some corporations may cost $5,000 or $10,000 rather than $1,000. In Australia, the face value of most corporate bonds is $100. Like other types of debt, bonds may have fixed interest rates that stay the same throughout the life of the bond, or they may have floating rates that change.
Why Do Corporations Sell Bonds?
Corporate bonds are a form of debt financing. They can be a major source of capital for many businesses, along with equity, bank loans and lines of credit. Generally speaking, a company needs to have some consistent earnings potential to be able to offer debt securities to the public at a favorable coupon rate. If a company’s perceived credit quality is higher, it becomes easier to issue more debt at low rates. When corporations need a very short-term capital boost, they may sell commercial paper, which is very similar to a bond but typically matures in 270 days or less.
The Difference Between Corporate Bonds and Stocks
When an investor buys a corporate bond, he lends money to the company. Conversely, when an investor purchases stocks, he essentially buys a piece of the company. The value of stocks rises and falls with the value of the company, allowing the investors to earn profits but also subjecting the investors to losses. With bonds, investors only earn interest rather than profits. If a company goes into bankruptcy, it pays its bondholders along with other creditors before its stockholders, making bonds arguably safer than stocks.
A type of bond, asset-backed securities (ABS) bundle together consumer debt, such as home loans, home equity lines of credit and credit card receivables. They may also include loans on mobile homes but not traditional mortgages. Institutional investors typically purchase ABS. ABS may be included in corporate bond mutual funds.
Investors considering fixed-income securities might want to research corporate bonds, which some have described as the last safe investment. As the yields of many fixed-income securities declined after the financial crisis, the interest rates paid by corporate bonds made them more appealing. Corporate bonds have their own unique advantages and disadvantages.
One major draw of corporate bonds is their strong returns. Yields on some government bonds have repeatedly plunged to new record lows. The U.S. government sold $12 billion worth of 30-year Treasury bonds for a 2.172% yield on July 13, 2016, breaking the previous record of 2.43% set in January 2015. The yields on German 10-year bonds also ventured into record-low territory, selling with a yield of negative 0.05%.
In contrast to these record lows, corporate bonds representing high-quality companies and maturing in seven to 10 years paid 3.14% yields on July 14, 2016. One year earlier, these securities were paying a yield of 3.92%.
Many corporate bonds trade in the secondary market, which permits investors to buy and sell these securities after they have been issued. By doing so, investors can potentially benefit from selling bonds that have risen in price, or buying bonds after a price decline.
Some corporate bonds are thinly traded. Market participants looking to sell these securities should also know that numerous variables could affect their transactions, including interest rates, the credit rating of their bonds and the size of their position.
There are many types of corporate bonds, such as short-term bonds with maturities of five years or less, medium-term bonds that mature in five to 12 years and long-term bonds that mature in more than 12 years.
Beyond maturity considerations, corporate bonds may offer many different coupon structures. Bonds that have a zero-coupon rate do not make any interest payments. Instead, governments, government agencies and companies issue bonds with zero-coupon rates at a discount to their par value. Bonds with a fixed coupon rate pay the same interest rate until they reach maturity, usually on an annual or semiannual basis.
The interest rates for bonds with floating coupon rates are based on a benchmark, such as the Consumer Price Index (CPI) or the London Interbank Offered Rate (LIBOR), adding a certain number of basis points (bps) to the benchmark. The interest payments change along with the benchmark.
A step coupon rate provides interest payments that change at predetermined times, and usually increase. Most of these securities come with a call provision, meaning that investors receive the initial interest rate until the call date. After reaching the call date, the issuer either calls the bond or hikes the interest rate.
One major risk of corporate bonds is credit risk. If the issuer goes out of business, the investor may not receive interest payments or get his or her principal back. This contrasts with bonds that have been issued by a government with a high credit rating, as this entity could theoretically increase taxes to make payments to bondholders.
Another notable risk is event risk. Companies could face unforeseen circumstances that could undermine their ability to generate cash flow. The interest payments – or repayment of principal – associated with a bond depend on an issuer’s ability to generate this cash flow. Corporate bonds can provide a reliable stream of income for investors. These debt-based securities became particularly attractive after the financial crisis, as central bank stimulus helped push the yields on many fixed-income securities lower. Interested investors can choose from many different kinds of corporate bonds, and these securities frequently enjoy substantial liquidity. However, corporate bonds also have their own unique drawbacks.
Corporate Bond Indices
Corporate bond indices include the Barclays Corporate Bond Index, S&P U.S. Issued Investment Grade Corporate Bond Index (SPUSCIG), the Citigroup US Broad Investment Grade Credit Index, the JPMorgan US Liquid Index (JULI), and the Dow Jones Corporate Bond Index.
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