Like government bonds, investors that purchase corporate bonds make a loan to the corporation that issued the bond. In exchange, investors receive interest on their principal and, in most circumstances, their principal when the bond matures if the company does not go burst.
To better understand bonds, we like to compare them to stocks. When you buy the shares of a company, you become an owner of the company and become entitled to any dividends declared and paid by the firm. On the other hand, when you purchase a corporate bond, you do not acquire ownership of the firm. You will only get the bond's interest and principal, regardless of how lucrative the firm grows or how high its stock price rises. However, even if the corporation gets into financial problems, it is still required by law to make regular interest and principal payments. Bonds are also different from stocks in that they are not traded on an exchange. It is generally much more difficult to buy and sell them than it is for stocks, although there are some exceptions. For example, you can trade government bonds through a broker or directly with the Treasury Department.
Companies use bond proceeds for various purposes, including R&D, acquiring new equipment, repurchasing their shares, refinancing debt, paying shareholder dividends, and supporting mergers and acquisitions. The most common use for bond proceeds is to fund capital expenditures. Capital expenditures are the costs of purchasing or upgrading equipment like machinery and vehicles and building new facilities. This type of expenditure allows businesses to expand their operations, which can lead to increased revenue in the future. Your belief in the company to make increased revenue in future is part of why you will invest in their bonds, as this gives you some guarantee that the company will likely not go bankrupt.
What happens in cases of bankruptcy?
Bondholders will have a claim on a company's assets and cash flows if it defaults on its debts (bonds) and goes bankrupt. The bond's provisions define the bondholder's place in line or the claim's priority.
Priority will be assigned based on whether the bond is secured, senior unsecured, or junior unsecured (or subordinated). In the event of a secured bond, the corporation promises particular collateral as security for the bond, such as property, equipment, or other assets owned by the company. Holders of secured bonds will have the legal right to foreclose on the collateral to settle their claims if the firm defaults.
Unsecured bonds, often known as debentures, have no collateral committed to them. Debentures have a broad claim on the assets and cash flows of the corporation. They can be either senior or junior (subordinated) debentures. Holders of senior debentures will have a more extraordinary priority claim on the business's assets and cash flows if the firm fails than holders of junior debentures. However, bondholders are not always the company's only creditors. Banks, suppliers, consumers, pensioners, and others may also owe the firm money, and some may have equal or higher claims than specific bondholders. Sorting through conflicting creditor claims is a complicated procedure in bankruptcy court.
What are the financial terms of a bond?
A corporate bond's fundamental financial terms are its face value (par value), price, maturity, coupon rate, and yield to maturity. These terms are essential to understanding how a corporate bond works, and how it fits into your investment portfolio.
- Yield to maturity: The yield to maturity is the return you’d expect from holding a bond to maturity. It’s an annualized rate of return that accounts for all potential payments over the bond’s life, including interest and principal.
- Bond’s face value: The face value is the amount a bond issuer promises to pay back at maturity. For example, a $1,000 bond will pay $1,000 when it matures. The face value of a bond does not change during its life.
- Bond’s Price: The price of a bond is the amount of money that must be paid to buy it. The price is usually a percentage of the face value (also called the par value). The bond’s price is also the amount of money you’d receive if you sold your bond.
- Coupon Rate: The coupon rate is the interest rate paid on a bond. It’s typically stated as a percentage of the face value, meaning that if you buy a bond with a face value of $1,000 and a coupon rate of 5%, you will receive interest payments of $50 every year until maturity.
- Maturity: The maturity of a bond is the date on which the issuer promises to repay the face value of the bond. For example, if you buy an 8-year bond with a face value of $1,000 and a coupon rate of 5%, you can expect to receive your initial investment plus interest payments until year 8.
What’s the relationship between bond prices, interest rates and yield?
Bond prices fluctuate in the opposite direction of market interest rates, much like the opposite ends of a seesaw. When interest rates rise, the bond's price falls. When interest rates fall, the bond's price rises. The yield on a bond moves inversely with the bond's price. Assume a bond pays 4% in interest and market interest rates fall to 3% a year later. The bond will continue to pay 4% interest, making it more attractive than newly issued bonds that pay only 3% interest. If you sell the 4% bond, the price will almost certainly be greater than it was a year ago. However, if the bond's price rises, so will its yield to maturity for each new buyer. Assume that market interest rates climb from 4% to 5%. If you sell the 4% bond, it will face competition from new bonds offering 5% interest. The 4% bond's price is more likely to decline. However, as the price falls, the yield to maturity for any new buyer will rise. It's crucial to remember that, despite market fluctuations, if you retain a bond until maturity, the bond will continue to pay the stated rate of interest as well as its face value upon maturity, subject to default risk.
How can investors reduce their risks?
Diversifying one's investments can help investors lower their risks. Bonds are a type of investment vehicle that can diversify one's portfolio. They are debt securities that represent an obligation from a company or government agency to pay the investor back at some point in the future. In exchange for lending money, investors receive interest payments over time until the bond matures and is repaid in full. Bonds, along with stock, cash, and other assets, can build a great portfolio if appropriately mixed. Investors can also diversify their bond holdings. Investors might, for example, acquire bonds with varying maturities or diversify their bond holdings by combining corporate, treasury, and municipal bonds. Investors with a higher risk tolerance may buy poorer credit-grade bonds, accepting more risks in exchange for higher returns. On the other hand, Conservative investors may opt to limit their bond holdings to high-quality bonds while avoiding riskier or more speculative bonds. Instead of owning bonds directly, investors can invest in bond-focused mutual funds or exchange-traded funds (ETFs).
How to research bonds or bond fund investment?
A prospectus is the offering document submitted to the Securities and Exchange Commission by a corporation that issues bonds for public sale in a registered transaction. A prospectus is also known as a disclosure document because it provides full and fair disclosure of all material facts relating to an offering. The SEC requires that the issuer provide investors with detailed information about the bond, including how much money will be raised in the sale and how it will be used. The prospectus for a corporate bond issue, among other things, details the terms of the bond, the substantial risks of participating in the offering, the financial health of the business issuing the bond, and how the firm intends to utilise the revenues from the bond sale. Similarly, if you invest in a bond-focused mutual fund or ETF, these funds will generate prospectuses outlining crucial fund information. Investors can obtain the prospectus for any bond or bond fund they are interested in from their broker/dealer. Prospectuses are also free to the public on the SEC's eDGAr website in the U.S. and in the UK you can search for bonds and their information on the London stock exchange website. The prospectus for a bond fund is also available on the bond fund's website. Finally, remember, the prospectus for a bond fund will give you all the information you need to decide whether or not this is an investment that’s right for you. It will also tell you what risks are associated with investing in bonds and how they can affect your portfolio as well as other factors like tax implications and fees. If you’re interested in investing in bonds, it’s important to do your research and understand what you’re getting into. The more information you have about the bond market, the better equipped you’ll be to make an informed decision when it comes time to invest.