Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Corporate Bond

What it is:

Corporate bonds are debt instruments created by companies for the purpose of raising capital. They are called fixed-income securities because they pay a specified amount of interest on a regular basis.

How it works (Example):

The bond itself represents a loan agreement between the issuer and the investor, and the terms of the bond obligate the issuer to repay the borrowed amount (the principal) by a specific date (the maturity). Some bond maturities are short-term (a year or less), others are intermediate-term (usually two to 10 years), and many are long-term (a period of 10 to 30 years or more). Bonds with maturities of less than 10 years are typically called notes.

The face value, or par value, of a bond represents the amount to be repaid at maturity. Corporate bonds usually have $1,000 face values, meaning that the issuer pays the holder $1,000 on the maturity date. Baby bonds have face values of $500. Note that the face value is not the market price of the bond.

Although issuers don’t usually repay the principal until the maturity date, they do usually pay the investor a specific amount of interest on a semiannual basis. (In some cases, when the bonds are serial bonds, specific principal amounts become due on specified dates.) The interest rate, or coupon rate, on a bond is the percentage of par, or face value, that the issuer pays the bondholder on an annual basis.

For example, you purchase a 5% bond (that is, a bond with a 5% coupon rate) from Company XYZ. The bond has a face value of $1,000. This means you will receive $50 in interest payments per year ($1,000 x 0.05). Corporate issuers usually make payments in six-month installments, meaning in our case that you would receive $25 in say, January, and the other $25 in June. The prospectus, the indenture agreement and the bond certificate all disclose the payment schedule.

Covenants, which can be found in the prospectus and the indenture agreement, require the issuer to do certain things and refrain from doing others.

Bond ratings are one way income investors can evaluate the risk of corporate bonds. Ratings agencies like Moody's and Standard & Poor's (S&P) research and analyze bond issuers and then grade their fixed-income securities.

Why it Matters:

In the grand scheme of investment choices, corporate bonds are relatively safe, liquid investments, but of course this depends on several factors, including the income investor's tolerance for risk and investment horizon. Corporate bonds are generally not safer than government bonds, certificates of deposit, or most municipal bonds, because corporations are more likely to default on their obligations than the U.S. government, local governments and banks. The added risk means that corporate bonds typically offer higher returns than these instruments.

Owning a company's debt is different in many ways from owning a company's stock. First, bondholders cannot vote and they are not entitled to dividends. Second, debt ranks senior to equity. This means that the bondholders are among the first in line to be repaid in the event the issuer liquidates. Shareholders might receive some proceeds from the liquidation after this point, if there is anything left. So seniority provides an extra level of security for bondholders, and this is one reason corporate bonds are generally considered “safer” investments than stock.

Companies want to borrow as cheaply as possible, so they can get creative in how they structure their bonds. For instance, a company might issue bonds that convert to other financial instruments (like stock), pay interest on an unusual schedule or carry unusual covenants. Despite the variety, there are some things that most corporate bonds have in common.

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