Corporate bonds are longer-term debt instruments issued by companies to raise money for business expansion.
These debt instruments usually have a maturity date of at least a year after issue. Corporate bonds with a shorter maturity are known as commercial papers.
How Do Corporate Bonds Deliver Yield?
Yield refers to the total amount from coupon payments as well as “built-in” appreciation in value. For instance, an investor may purchase a $100 corporate bond for $95, with an annual coupon payment of $10, or $5 biannually. The current yield would be 10.5% ($10 /$95). The investor would also profit from the built-in price appreciation of $5 by holding the bond to maturity and receiving the par value of $100. Some companies issue zero-coupon bonds, the current yield of which is zero, while the yield to maturity is only a function of the built-in appreciation in value.
Benefits of Corporate Bonds
Here are some benefits of corporate bonds:
- Attractive yields: Corporations generally offer higher yields than government bonds of the same maturity.
- Dependable income: Corporate bonds offer investors the opportunity of a steady income, while preserving the principal.
- Safety: Credit rating agencies, like Standard & Poor's and Moody's, rate corporate bonds according to associated risk and rewards.
Ratings reflect the capability of the issuing authority to deliver timely returns. The higher the rating, the safer the investment.
- Diversity: An investor can choose from a variety of sectors and credit-quality characteristics.
- Marketability: Most corporate bonds sell easily and quickly due to the market’s size and liquidity.
Drawbacks of Corporate Bonds
While corporate bonds offer a higher yield than some other investments, they are also accompanied by higher risks. These include:
- Interest Rate Risk: Interest rate movements can significantly reduce the value of the bond.
- Credit Risk: Corporate bonds are not secured by collateral.
Thus an investor faces the risk of a corporation failing to meet the debt obligation.
- Event Risk: Corporate bonds have exposure to event-based risks. Corporate reshuffles,
takeovers or restructuring have far reaching consequences on the credit rating and price of such bonds.
- Call Risk: Callable corporate bonds can be a nightmare when the issuer declares the purchase of bonds after a stipulated time period.
Corporations usually call off a high-yielding bond when interest rates plummet. This gives the company a chance to reissue bonds
at lower interest rates. In such cases, an investor receives only the par value of the bond.