Don’t miss these three things when investing in corporate bonds

Corporate bonds are securities issued by a private or public limited company to raise debt funds from investors. As an individual investor, you can buy at launch or from the secondary market after the bonds get listed on exchanges.

Bonds are issued for specific tenures and on maturity, you will receive your initial principal, plus any remaining interest payouts.

The lure of corporate bonds lies in the periodic interest and the relatively lower fluctuation in investment value. However, investing in these is not as simple a task and there are a few things you need to keep in mind.

Yield of the bond is not the coupon rate

In the secondary market, alongside the price of a bond, you will also see the yield. This is expressed as a percentage and can easily get mistaken for the coupon, which is also expressed as a similar percentage.

The coupon is the periodic interest payment that the bond issuer promises to pay the holder. For example, an 8% per annum coupon for a bond of face value Rs 1000 means you will get Rs 80 per bond as the one-year interest.

The yield on the other hand is a term related to the market price of a bond rather than its face value. It represents what you will earn from buying the bond.

Assume that the current market price of the 8% coupon bond is Rs 950. The price has fallen because interest rates have gone up from the time the bond was issued. Similar bonds are now paying an 8.5% coupon rate, making them more attractive.

However, since you will be able to buy a Rs 1000 bond for Rs 950 and earn the original coupon, your yield becomes 8.42%. This is the simplest form of market yield.

This does not account for the time period or the maturity value you receive or the frequency of interest payments.

Market yield is what bonds are compared on when a buying decision is made for listed bonds. If the market yield is higher than the coupon, it means the bond price is at a discount to the face value and vice versa.

The issuer of the bonds

The issuer of the bond is of primary importance. If the issuer is a poor-quality company or an unreliable promoter, then the chances of default are high.

Bond defaults are not uncommon and individual investors have to focus on good quality in order to escape this risk. Credit rating agencies assign ratings of quality to all publicly issued bonds.

The highest quality bond is rated AAA, next is AA, then A, BBB and so on. A C rated bond is poor quality and D rated bond is known as junk.

Not only should you be aware of the official credit rating assigned to the bond, but also the general reputation of the issuer.

Lastly, assess the industry that the issuer operates in to understand macro risks to the cash flows of the company. For example, till some time back, bonds from the real estate sector were struggling to meet their financial obligations because of poor demand and sales in the entire sector.

Liquidity of the bonds

Liquidity simply means the total number of units of a particular bond available in the secondary market for buying or selling.

While this may not be apparent when you are buying, because the bond is available for purchase, in case of selling liquidity can become an issue. If on the day you want to sell, there are no buyers, you will be forced to wait or accept a price that is lower than the market price.

It would be a good idea to track the daily liquidity of the bond you are interested in for a few weeks or months, before making the purchase. This will give you an understanding of how strong or weak it is.

Takeaway