What are corporate bonds?

4.6

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In the previous chapter, we saw how governments raise funds for their operations through the bonds and securities route. Now, bonds can prove to be quite useful this way, not only to governments but to companies as well. For companies in need of additional funds, external financing through loans is one option. Raising money through bonds is another. The bonds issued by companies are, once again, debt instruments. They’re known as corporate bonds. 

In this chapter, we’ll delve into the details and get to know all about corporate bonds.

What are corporate bonds?

Corporate bonds are debt instruments that are issued by private and public companies in India. These debt securities are issued to investors - both institutional and retail - and the company that issues the corporate bond utilizes the funds mobilized for the specific purposes. In return, investors are paid interest at periodic intervals regularly throughout the tenure of the bond. At the end of the tenure, on the redemption date, the company returns the principal to the investor.

Much like how government bonds are backed by the sovereign guarantee of the government, corporate bonds are backed by the company issuing the bonds. Generally, investors rely on the company’s future operations and profits as the backing needed for the debt given. However, in some cases, companies may also pledge their physical assets as collateral.

Why do companies raise funds through corporate bonds?

If companies need additional funds, they can resort to loans or even launch an IPO, isn’t it? What, then, is the need for corporate bonds? If that’s what you’re wondering, let’s get this dilemma sorted. In the case of IPOs, only public listed companies can launch Initial Public Offerings. So, private companies or unlisted companies need to find another way to raise funds.

This is where corporate bonds come in. Through these debt instruments, companies can fund their operations and projects, because corporate bonds help raise capital for the company issuing them. They act as a long-term financing option, which is not the case with loans taken from banks. 

What are the different types of corporate bonds available?

Corporate bonds come in different shades. Knowing how they’re classified, and the basis on which such classification or differentiation happens, can help you make the right investment choices. So, let’s look at the different types of corporate bonds available in the debt market.

On the basis of the maturity period:

The maturity period is the tenure after which the bond is redeemed. 

  • Short-term bonds: These bonds have maturity periods less than 1 year.
  • Medium-term bonds: Medium-term bonds come with maturity periods between 1 and 5 years.
  • Long-term bonds: Long-term corporate bonds are typically issued for over 5 years.
  • Perpetual bonds: Perpetual bonds, as the name suggests, are debt securities that do not have any maturity period.

On the basis of the nature of interest:

  • Zero coupon bonds: Much like T-bills and CMBs, zero coupon corporate bonds do not carry any rate of interest. Instead, they are issued at a discount and redeemed at face value.
  • Fixed rate bonds: These are corporate bonds that pay out interest to the investor at a fixed rate throughout the tenure.
  • Floating rate bonds: In floating rate bonds, the interest rate is periodically reset based on the benchmark rate.

In addition to the above types of corporate bonds, companies can also issue convertible bonds. Essentially, these are bonds that can be converted into a predetermined number of equity shares. Like other corporate bonds, convertible bonds also pay out interest to the bondholder. And at certain points of time during the tenure of the bond, the bondholder can choose to convert the bonds they hold into the specified number of equity shares, if they wish to.

How can you invest in corporate bonds?

If you’re looking for a relatively safe investment option that gives you exposure to a particular industry, but find equity too high-risk for your risk profile, corporate bonds may be the ideal tradeoff. To invest in these bonds, you will need a demat account.

You can invest in corporate bonds in any of the following ways.

  • You can invest in these debt instruments via the primary issue. 
  • You can also invest in them through the secondary market, by buying them from Bond Trading Institutions.
  • Alternatively, you can choose to invest in debt funds that focus on corporate bonds. We’ll look into the details of debt funds in the upcoming chapters.

Corporate debt or corporate equity: Which one should you choose?

You’ve perhaps deciphered by now that when it comes to raising money from the markets, companies have two courses of action - equity and debt. So, if you’re interested in investing in a company, which instrument should you choose? Corporate debt or corporate equity? 

Each type of investment comes with its own key features. Understanding these nitty gritties can help you make the right choice between them, based on what suits your investment goals best.

Particulars

Corporate equity

Corporate debt

Nature of investor’s role

Part owner of the company

Creditor to the company

Income received

Dividend

Interest

Effect of increasing profitability of the company

Possible increase in dividend rates

Interest tends to remain constant (in fixed rate bonds)

In case of a financial crisis in the company

No obligation to pay dividends

Obligation to pay interest remains unchanged

In case of bankruptcy of the company

Equity shareholders are paid last, if at all

Bondholders are prioritized and are obligated to be repaid

Understanding bond yield

That sums up the discussion on corporate bonds. However, before we wrap things up, there is one other important concept pertaining to bonds (both corporate and government) that we need to discuss - the bond yield. 

So, what is bond yield? 

Simply put, it is the rate of return on the amount you invest in a bond. At first glance, it may appear to be the coupon rate or the interest rate. But that is a common misconception. The interest rate may be fixed, but the bond yield keeps fluctuation based on the price movements of the debt instrument. 

Back up a bit. Did we just say ‘price’ of the bond? Yes, you read that right. The price of the bond is calculated as the sum of the present value of all future cash flows that are to be received from the bond. Remember the present and future value calculations we looked at in an earlier chapter? This is calculated in a similar manner.

Types of bond yield

There are three types of bond yield that you should know about.

  • The coupon yield
  • The current yield
  • Yield to Maturity (YTM)

Coupon yield

This is simple enough. It’s just the coupon yield or the interest payment made on the face value of the bond. Calculating the coupon yield is easy. Check out the formula here.

Coupon yield = Coupon payment ÷ Face value

For example, consider this information.

  • Interest paid on a bond = Rs. 7
  • Face value of the bond = Rs. 100
  • Market value of the bond = Rs. 102

Here, the coupon yield will be 7% (Rs. 7 ÷ Rs. 100).

Current yield

The market value of a bond fluctuates often. It could be higher or lower than the bond’s face value. The current yield gives you an idea of how much you earn with reference to the market value of the bond. Mathematically, the current yield is the interest amount expressed as a percentage of the bond’s purchase price. 

Current yield = (Annual interest payment ÷ Purchase price of the bond) x 100

For example, consider this case where a bond is purchased at a premium.

  • Interest paid on a bond = Rs. 7
  • Face value of the bond = Rs. 100
  • Purchase price of the bond = Rs. 110

Here, the coupon yield will be 6.36% [(Rs. 7 ÷ Rs. 110) x 100].

On the other hand, take this case where the bond is purchased at a discount.

  • Interest paid on a bond = Rs. 7
  • Face value of the bond = Rs. 100
  • Purchase price of the bond = Rs. 90

Here, the coupon yield will be 7.77% [(Rs. 7 ÷ Rs. 90) x 100].

Yield to Maturity (YTM)

The YTM shows you the total return you will earn if you hold the bond till maturity. Hence, it’s essentially the yield to maturity. The YTM takes into account all the interest payouts as well as any capital gain that you may earn (if you purchased the bond below par) or any capital loss you will incur (if you purchased the bond above par).

The relationship between bond price and bond yield

The price of the bond and its yield are interlinked.

  • If the market price of the bond is equal to its face value, it means the bond is selling at par. Here, the YTM = coupon yield.
  • If the market price of the bond is less than its face value, it means the bond is selling at a discount. So, the YTM > coupon yield.
  • If the market price of the bond is more than its face value, it means the bond is selling at a premium. So, the YTM < coupon yield.

Wrapping up

With the discussion on corporate bonds coming to a close, it’s now time to venture into the intersection of the debt market and the mutual fund market. Keep reading to discover debt funds in the next chapter. 

A quick recap

  • Corporate bonds are debt instruments that are issued by private and public companies in India. 
  • These debt securities are issued to investors - both institutional and retail - and the company that issues the corporate bond utilizes the funds mobilized for the specific purposes. 
  • In return, investors are paid interest at periodic intervals regularly throughout the tenure of the bond.
  • Corporate bonds can be short-term, medium-term, long-term or perpetual.
  • They can also be classified as zero coupon, fixed rate, or floating rate bonds.
  • Bond yield is an important concept that shows you how much you earn on your investment.
  • There are three types of yield: coupon yield, current yield and YTM.
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