Corporate Bonds - How Does A Corporate Bond Work?
For more than a decade, low interest rates have made things tough on investors looking for income. In some cases, corporate bonds might offer a solution.
Corporate bonds often offer higher interest rates than common income-producing choices such as savings accounts, CDs and Treasury bonds. However, corporate bonds also involve certain risks in exchange for those higher income yields.
Deciding whether corporate bonds are right for you starts by understanding both the return potential and the risk involved. This article provides more information to help you learn how to evaluate corporate bonds. Here are the topics explored:
- What is a corporate bond?
- Basic bond terminology
- How corporate bond yields compare with Treasury yields
- What drives the return of corporate bonds?
- What are the risks of corporate bonds?
- Different ways to invest in corporate bonds
What is a Bond?
A bond is a type of debt obligation. It's a form of loan where the issuer of the bond is the borrower and the owner of the bond is the lender.
When the issuer sells a bond, in exchange for the money it gets, it promises to make regular income payments and repay the principal on a certain date.
After the bond has been issued, it can be bought or sold by investors and its price can go up or down based on investor demand. Whoever buys the bond is entitled to the regular interest payments that come due as long as they own the bond. Whoever owns the bond when the principal is due to be repaid is entitled to that principal.
Bonds are issued regularly by the federal government, and sometimes by state and local governments. Corporations often issue bonds when it is cost-effective for them to borrow money.
Key Parts of Corporate Bonds
When looking at corporate bonds, it is important to know the key characteristics of those bonds, including those described below.
This is the amount of money due to be repaid on the bond. Bonds are generally issued with a par value of 100.
If the price of a bond moves above 100, it is said to be trading above par. If the price moves below 100, it is said to be trading below par.
This is the current price of the bond, as determined by trading activity in the market. Some of the factors that drive bond prices are discussed below.
This is the date on which the principal is due to be repaid and interest payments cease.
This is the percentage interest payment that the bond makes at regular intervals. Corporate bonds typically pay interest every six months, but some may pay interest on a different cycle.
Just like individuals have a credit score, bond issuers are rated based on the strength of their finances. This is a general estimate of an issuer's ability to meet its bond obligations, but it is based primarily on current conditions. It does not necessarily predict future changes to an issuer's finances.
A bond's credit rating is often referred to as its "quality." Bond rating agencies have several quality tiers, but these are generally split into two major levels - investment grade for higher rated bonds and non-investment grade for lower quality bonds.
Corporate Bond Yields, Interest Payments and Prices
To understand corporate bonds, you need to understand the relationship among corporate bond yields, coupon payments and prices.
If a corporate bond is held to maturity and does not default on its interest and principal payments, the return on that bond will be determined by two things:
- The periodic interest payments made
- The difference between the price paid for the bond and the par value of the bond
The amount of the interest payments on most bonds is fixed, but the price of the bond can vary. The percentage of the price that the interest payments represent is known as the income yield.
As bond prices drop, interest payments represent a bigger percentage of the price so the income yield of the bond rises. This means the bond offers a better return to investors going forward.
If a bond is held to its maturity date, the difference between the current price and the par value of the bond will also impact the return. Note that if the bond is purchased above par, this difference will negatively impact the return to the investor. If the bond is purchased below par, the difference will add to the investor's return.
Corporate Bond Opportunities
Corporate bond opportunities, therefore, come from a combination of the income yield on the bond and the difference between the purchase price and either the par value at maturity or the price at which the bond is subsequently sold.
This combination of the income yield and the difference between price and par value make up a bond's yield to maturity. This is the annual percentage return the bond would produce at the current price if held till the maturity date.
The yield to maturity on corporate bonds is generally higher than that of Treasury bonds. This is because investors are more confident that the U.S. government will be able to meet its payment obligations, so they demand a higher yield if they are going to invest in a corporate bond instead.
Investors will often sell a bond before it reaches the maturity date if there has been a favorable price movement. Two things can cause a corporate bond's price to rise:
- If interest rates on similar bonds generally fall, the coupon of a corporate bond will be more attractive. Prices will generally rise until the yield on the bond is at the level of similar bonds.
- If a bond's credit rating improves or investors otherwise become more confident in the issuer's ability to meet future interest and principal payments, the bond's price is likely to rise.
Therefore, if investors find the bond's yield to maturity attractive or they expect either of the above two events to occur, the bond may represent an attractive opportunity.
Corporate Bond Risks
Along with investment opportunity, corporate bonds also involve certain risks. Here are some risks to consider before buying corporate bonds:
The interest and principal on most corporate bonds are guaranteed only by the corporation itself. If that corporation runs into financial difficulty, it may default on some or all of those payments. The risk of this happening is known as default risk.
Therefore, buying a corporate bond should entail considering the current financial condition of the company, its prospects for the future, and the general business environment.
Even if a corporation has not defaulted on a bond, the credit rating of the bond may be downgraded if the risk of the issuer defaulting in the future has increased.
When a bond's rating is downgraded, its price typically drops. So, the possibility of a bond's rating being downgraded is a risk to investors.
Interest rate risk
All bonds are subject to interest rate risk. This risk results from changes in interest rates throughout the economy.
If interest rates rise, the yield at which you bought the bond would no longer look as competitive compared to the new, higher level of rates. That would make the price of the bond fall until its yield was in line with current interest rates.
There are several different types of interest rates. Corporate bonds would be most affected by general changes in rates for bonds with similar quality ratings and maturity dates.
Duration is a measure of the average amount of time it would take for an investment in a bond to be repaid. Duration is a function of the size of the regular interest payments and the maturity date when the principal amount of the bond will be paid.
The longer a bond's duration, the more time there is for something to go wrong. Therefore, long-duration bonds are generally riskier than short-duration bonds.
Corporate Bond ETFs and Other Funds
Besides buying corporate bonds individually, you can invest in them via exchange-traded funds (ETFs), mutual funds or other collective vehicles.
Buying corporate bonds via a fund can help you by a diversified selection of bonds and can also make trading more cost effective.
However, buying bonds in a fund also adds some special risks.
Funds typically have management fees and other operational expenses. These expenses can eat into the return you earn on your investment, or in some cases wipe it out altogether.
Also, the yield-to-maturity on a bond is the return based on an assumption of holding onto the bond until its maturity date. However, with bond funds, you have no control over whether the bond manager will sell the bond before it matures. If the bond manager's trades are ill-timed, your return may be lower than the fund's yield when you bought it and below the return of similar bonds generally.
Investing in Corporate Bonds
Even though funds can add to the risk and the expense of owning corporate bonds, they may be the only option for some investors because they typically trade in very large increments.
Corporate bonds represent a total return and an income opportunity for investors. The better you understand the bond issuer, the interest rate environment and the risks involved, the better able you will be to judge the quality of that opportunity.