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How does a corporate bond work?

A corporate bond is a type of fixed income security issued by corporations or companies to raise money from investors. The company issuing the bond gets the capital they need, and in return, they pay the investor interest. Upon expiry of the bond, the company pays back the money to the investor.

When a corporate bond is issued, the investor will become the lender, the company issuing the bond will become the borrower. Most of the time, the company’s ability to repay is taken as collateral. One can assess the ability to repay through future revenues and profitability. In some cases, the collateral can be the firm’s physical assets.

An investor need not worry about assessing a firm’s financials before investing in a corporate bond. Every corporate bond is rated by credit rating agencies. The rating agencies like CRISIL rate the bonds from AAA to Default, with AAA being the highest rating. A AAA corporate bond is considered to be very safe, and the risk of default is almost zero. The interest rate of AAA bonds is less when compared to the bonds rated below it.

What is the risk of corporate bonds?

Corporate bonds are fixed income instruments. The company borrows the money from investors and pays them interest until the bond matures. Upon maturity, the company pays back the principal amount. There is a risk that the company might default on the payment. Additionally, during a rising interest rate regime, the value of the corporate bonds fall. Therefore corporate bonds are prone to default or credit risk and interest rate risk.

Credit risk

Corporate bonds are rated by credit rating agencies. The bonds rated AAA are considered as safe as the risk of default is almost zero. However, as the rating falls, the risk of default increases. Hence to compensate for it, the bonds having lower credit rating have a higher interest rate.

However, there is no guarantee that bonds that have a high rating might not default on payments. Hence there is always an element of credit risk present in all corporate bonds.

Interest rate risk

Corporate bonds are long term debt securities. During the tenure of the bond, the interest rates in the market keep changing. In a rising interest rate regime, the value of the corporate bonds fall. This is because, when the interest rates rise, the opportunity cost for the investor for holding these bonds increases. The investor might be able to get a higher interest rate for the same value of the bond. Therefore to compensate for that, the bond prices must fall.

When the interest rates rise, investors automatically switch to bonds paying the higher interest rate. Hence the value of the existing bonds fall. The investors will face trouble in selling the low value bonds against the new attractive ones in the market. Additionally, the market value of the bonds held by the investor may go below the initial purchase price, leading to losses for the investor.

Are corporate bonds safer than stocks?

Corporate bonds are a type of debt securities issued by public and private corporations. The main purpose of issuing them is to raise money to meet the business requirement. When an individual buys a corporate bond, they are lending money to the issuer (company) of the bond. As a result, the issuer promises to return the money on the predetermined maturity date and interest rate.

On the other hand, stocks are equity instruments. A stock is also known as a share. It is ownership security. In simple words, stocks are shares of ownership in a company. The company doesn’t have any obligation to issue a dividend to the stockholder.

Stocks do not earn regular income or interest income like corporate bonds. The gains from stocks are when the company issues dividends or upon sale (when the market price of the share rises in comparison to the initial buy price). Share prices are subject to market volatility and hence are considered to be riskier than debt securities.

Bonds are good investment options for portfolio diversification. However, it is important to note that corporate bonds have the credit or default risk and inflation risk associated with them. The issuer may default their payments resulting in loss to the investor.

What are the disadvantages of bonds?

Following are the disadvantages of corporate bonds:

  • Risk of losing money
  • Interest rate fluctuations
  • Lower returns than long term equities

Risk of losing money

Companies issue corporate bonds, and they might default on payments. In case of default, the bond investors will be considered first for payment, and they might get only peanuts. Hence there is always a risk of losing the investment.

Interest rate fluctuations

During interest rate fluctuations, the value of the bond will fluctuate too. If the interest rates rise, the bond might seem unattractive to investors, and the value of the bond will fall drastically. The investor might face a problem selling the bond in the secondary market.

Lower returns than long term equities

Corporate bonds are long term investments, and the returns from them might not match the returns from investing in equities for the same tenure. Equities have the potential to give higher returns in the long term. For the same tenure, these debt securities might not give similar returns.

What are the advantages of corporate bonds?

Following are the advantages of investing in corporate bonds:

  • Higher returns
  • Tax efficiency
  • Liquidity
  • Tenure and Coupon structure

Returns

Corporate bond funds may generate higher returns. The investor by investing in them is undertaking significant risk when compared to other government bonds. Therefore, the higher the risk, the higher are the returns. Moreover, these bonds have a higher growth potential than government bonds.  Additionally, the companies also make regular coupon payments to their investors.

Tax efficiency

Corporate bonds are long term investment options with durations for more than three years. Therefore, investing for three years will have a tax advantage. These funds are taxable at 20% with indexation benefit. Hence, investors falling under the highest tax bracket may benefit from this the most.

Liquidity

Most corporate bonds trade on the secondary market. In other words, one can buy and sell these securities even after their issue. Therefore, an investor can sell if the bond prices increase or buy when the prices fall.

Tenure and Coupon Structure

Bonds have different maturities. For example, there are long term, medium term, short term, and perpetual corporate bonds available for investors to choose from. Similarly, bonds have different coupon structures. An investor can choose the coupon structure that best suits them. For example, fixed-rate, floating-rate and zero-coupon bonds.

Published on October 27, 2020