What are Corporate Bonds?
Corporate Bonds are debt issuances by public and private companies to raise capital in exchange for periodic interest payments and the full repayment of principal at maturity.
Corporate Bonds Features
Corporate bonds are debt obligations issued by companies to fund operations, expansion strategies, or acquisitions.
Typically, corporate bonds are raised after the availability of senior debt from risk-averse bank lenders “runs out” – or, in other instances, the issuer might prioritize longer-term financing and less restrictive covenants at the expense of higher interest rates.
From the perspective of the lender, capital is provided to the issuer in exchange for:
- Series of Interest Expense Payments
- Repayment of Original Principal at Maturity
Corporate bonds are issued in standardized blocks of $1,000 in face value (i.e. par value).
Furthermore, the maturities on corporate bonds can range from short-term, mid-term, or long-term.
- Short-Term: < 1 to 3 Years
- Mid-Term (Intermediate): Between 4 to 10 Years
- Long-Term: > 10+ Years
Corporate Bond Interest Rate Pricing
The pricing on corporate bonds – i.e. the interest rate – should reflect the risk profile of the issuer (and the required yield).
If the issuer meets all interest payments on time and repays the principal as agreed, the lender can obtain higher yields than government bonds with comparable maturities.
The higher the default risk, the higher the corresponding interest rate as there needs to be extra compensation to the lender for taking on the additional risk.
All corporate bonds carry some degree of credit risk, in which the issuer could potentially default and be unable to meet required interest or amortization payments per the lending agreement.
To protect their downside risk, lenders perform due diligence on the borrower as part of the credit analysis process, which could warrant favorable (or unfavorable) pricing, analyzing the borrower’s:
- Free Cash Flows (e.g. FCFF, FCFE)
- Profit Margins
- Debt Capacity
- Leverage Ratios
- Interest Coverage Ratios
- Debt Covenants
- Liquidity Ratios
- Solvency Ratios
Interest Rate and Liquidity Risk
Bonds prices have an inverse relationship with interest rates – so if interest rates were to rise, bond prices should fall (and vice versa).
The potential for rising interest rates to cause the market prices (and yields) on bonds to decline is called “interest rate risk.”
Another type of risk is “liquidity risk,” in which limited demand in the market when attempting to exit a position can result in the seller having to resort to discounts in order to find an interested buyer.
Corporate Bonds vs Government Bonds
Corporate bonds are riskier than U.S. government bonds, which are often called “risk-free” as they are government-backed.
The spread on the corporate and government bonds yields are frequently graphed against each other – i.e. to measure the yield in excess of the risk-free rate.
Unlike the government, which can theoretically continue to print money to avoid defaulting on debt obligations, corporates can be forced to file for bankruptcy after a default (and undergo liquidation in the worst-case scenario).
Even though corporate bonds are less liquid than government bonds, corporate bonds are still very actively traded in the secondary market.
Assuming the issuer is a well-known public company with a strong credit profile, bonds can usually easily be sold prior to maturity, barring unusual circumstances.
Fixed vs. Floating Interest Rate Terminology
Generally, corporate bonds are categorized within fixed income, in that the interest expense – i.e. called “coupon payments” – is calculated and paid based upon on the issuance amount.
- Interest Payments ➝ Coupon Payments
- Interest Rate ➝ Coupon Rate
The majority of corporate bonds pay interest on a fixed, semi-annual basis, meaning that the stated coupon on the bond remains constant throughout the bond’s entire term (i.e. tenor).
Given a fixed coupon rate structure, the coupon payments remain fixed regardless of changes in the prevailing interest rates in the market or economic conditions.
Fixed Coupon Rate – Example Calculation
The interest payment on a bond is calculated as a percentage of the par value, so if we assume a $1,000 par value and 6% fixed interest rate, the annual coupon comes out to $60.
- Coupon = $1,000 x 6% = $60
In contrast, the interest rate on a floating-rate corporate bond fluctuates based on a spread above an underlying benchmark.
Formerly, the globally accepted benchmark was LIBOR, but LIBOR is currently being phased out and soon will be replaced by the secured overnight funding rate (SOFR).
One exception to interest-bearing bonds is zero-coupon bonds.
Rather than paying periodic interest, zero-coupon bonds are sold at a steep discount and redeemed for the full face value on the date of maturity.
Investment Grade vs. High-Yield Corporate Bonds
Bond issuers with poor credit ratings typically pay higher interest rates, as investors require additional compensation for the incremental risk – all else being equal.
In the U.S., the creditworthiness of publicly-traded companies is rated by three major credit rating agencies:
- Standard & Poor’s (S&P)
Credit agencies are responsible for publishing independent credit ratings on the bond issuer’s default risk – i.e. the likelihood of servicing interest payments and mandatory repayments on schedule.
Generally, the ratings fall under two categories:
- Investment-Grade: If a bond issuer is rated as investment-grade, the company’s debt is considered lower risk, resulting in lower interest rates.
- High-Yield: Conversely, high-yield bonds (i.e. non-investment grade) are more speculative in nature and thereby carry higher interest rates to reflect the increased risk of default.
Callable vs. Non-Callable Features in Bonds
If a corporate bond is callable, then the issuer of the bonds can repay a portion of the bonds earlier than scheduled or redeem the entire tranche prior to the stated maturity date.
If a bond is callable, the issuer may decide to opt to repay it – which typically occurs when the prevailing interest rates in the markets decline substantially (i.e. so that the issuer can refinance long-term debt at lower rates).
Within the bond debenture (i.e. lending contract), the guidelines on prepayment will be clearly stated, including when the bonds become callable and, if applicable, any prepayment penalties.
Since a pre-payment means that the lender has received fewer interest payments, there are often periods in which a bond is uncallable as well as additional fees the borrower must pay to the lender if it chooses to call (i.e. repay) the bond prior to maturity.
Corporate Bonds vs. Equity
Unlike equities, corporate bonds do NOT represent ownership stakes in the underlying company.
Given the set interest rate and maturity date, the potential return to the debt investor is “capped” – ignoring convertible debt and related debt securities (i.e. mezzanine financing).
The lending agreement outlines the interest payment schedule and principal repayment, which remains in effect regardless of how profitable the issuer becomes (or if its share price rises).
By contrast, the potential upside from holding equities (i.e. shares in the company) is theoretically unlimited.
In the event of default, debt lenders are therefore far more likely to recover some (or even all) of their initial capital.