What is Corporate Bond?
A corporate bond is a type of debt instrument issued by companies to raise capital from investors. When an investor purchases a corporate bond, they are effectively lending money to the issuing company.
In return, the corporate bond issuing company commits to making periodic interest payments, called coupon payments, and repaying the principal amount (the bond’s face value) upon maturity.
Corporate bonds typically offer higher interest rates than government bonds due to the increased risk, including the chance of default, reflecting the financial health and creditworthiness of the issuing company.
How Do Corporate Bonds Work?
Corporate bonds serve as a means for businesses to borrow money from investors with the promise of an interest-bearing repayment schedule.
Here’s a detailed outline of the fundamental mechanism involved:
1. Issuing of Bonds
A business can issue corporate bonds when it needs to raise money for operations, expansion, or other needs. Usually, this procedure entails:
1.1 Calculating the Sum
The business determines the capital required and issues bonds to cover the shortfall.
1.2 Term Setting
The bond’s face value, or the amount repaid at maturity, interest rate, or coupon, and maturity date—or the date the principal is repaid—are all set by the company.
2. Purchase by Investors
2.1 Payments of Interest
Depending on the bond’s interest rate, investors typically receive coupon payments every year or semi-annually.
2.2 Principal Repayment
The company returns the bond’s face value to bondholders when it matures.
3. Borrowing and Repayment
3.1 Borrowing
The company raises capital from investors by issuing bonds and retaining ownership and equity in the company.
3.2 Repayment with interest
The company must pay interest regularly over the bond’s life. At maturity, the principal amount must be repaid. For investors, this means a steady stream of cash.
Types of Corporate Bonds
Corporate bonds can be categorized according to many different criteria.
The primary types are as follows:
1. High-yield Bonds (Junk Bonds)
High-yield bonds (junk bonds) are issued with a higher default risk of default. They pay higher yields to provide investors with compensation for the extra risk but are more vulnerable during economic fluctuations.
2. Convertible Bonds
Convertible bonds enable investors to convert their bond positions into company shareholdings after the price of common stocks reaches an agreed-upon conversion rate. This provides the opportunity to profit from an increase in the company’s stock price while still receiving fixed interest payments until conversion.
3. Callable Bonds
Callable bonds allow the issuing company to redeem the bonds before their scheduled maturity date. This feature benefits companies when interest rates drop after the bond issuance, as it enables them to refinance the debt at a lower interest rate, reducing overall borrowing costs.
4. Zero-Coupon Bonds
Zero-coupon bonds do not pay periodic interest. Instead, they are issued at a discount to their face value and mature at their full face value. Investors receive a lump sum payment at maturity, which is the difference between the purchase price and the face value.
5. Senior Secured Bonds
Senior secured bonds have designated collateral backing them up. Collateral can be used to satisfy bondholders in default; they have priority over other creditors.
6. Senior Unsecured Bonds
In the event of default, secured bondholders have priority over senior unsecured bondholders, who are not collateralized. The general assets of the business are used to pay them off.
7. Subordinated and Junior Bonds
Regarding repayment priorities, junior and subordinated bonds come in lower order than senior bonds. In default or bankruptcy, they are only settled when senior bondholders receive full repayment.