What are Corporate Bonds?

Introduction

A corporate bond in its simplest form is a contract detailing a loan between an investor and a company. The investor agrees to give the company an amount of money in exchange for regular interest payments and an expectation that the company will repay the loan at a pre-agreed date, known as the "maturity date".

Please remember, as with all in investing there are always risks, so you could get back less than you put in. Read more about the benefits and risks of corporate bonds.

Principal Amount

The “principal amount" is the amount borrowed by a company. The company will decide which currency or currencies it wants to borrow in and for how long it wants to borrow for. It may issue one corporate bond, or it may issue several.

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Coupon

A coupon is the interest the company pays the bondholders.

Typically these payments are paid semi-annually until the corporate bond matures. Just like a mortgage or car loan, interest payments must be made on specific dates. These dates are set out when the corporate bond is first issued.

A corporate bond is said to have “accrued” interest between and up to interest payment dates.

A corporate bond with a 5% coupon will pay 5% annually on its debt. If it is £100 million in size this means that the borrower will pay £5m in interest to its bondholders each year. The date on which a coupon is payed is called the coupon date.

Coupons are normally described in terms of percentage rates. You can calculate this rate by adding the sum of coupons paid per year and dividing it by the principal amount. For instance, if a corporate bond has a principal amount of £1,000 and a coupon rate of 10%, then it pays £100 every year. However, interest payments are often paid semi-annually so this would mean two payments of £50 each.

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Current Yield

The "current yield" describes the yield based on the coupon rate and the current market price of the corporate bond (not on its face or par value).

Current yield is calculated by dividing the annual interest to be earned by its current market price.

For example, a £1,000 corporate bond selling for £850 and paying an 8% coupon rate (or £80 per year) has a current yield of 9.41% (the quotient of £80 divided by £850). The coupon rate in this example is 8% (80/1,000).

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Yield to Maturity

"Yield to Maturity" is the estimated annual return you will receive if you hold the investment until maturity.

Yield to maturity assumes that the corporate bond will be held to maturity, and that all interim cash flows will be reinvested at a rate equal to the yield to maturity.

If the corporate bond is not held till maturity, or if interim cash flows are reinvested at a rate that differs from the yield to maturity, an investor's actual yield will differ from the yield to maturity.

Since the yield to maturity calculation equates a corporate bond's cash flows to its current price, this yield calculation considers both coupon income and any capital gain or loss the investor will realise by holding the investment till maturity.

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Floating Rate Notes

A floating rate note is a type of corporate bond which pays a variable coupon that is LIBOR (London Inter-bank Offered Rate) plus a quoted spread. For example, the coupon might be L+5% which means the bond will pay a coupon that is 5% above the current LIBOR rate.

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Par Value

Corporate bonds are issued at "par" which is 100% of its value and is the amount that is to be repaid at maturity. Investments trading above 100 are trading at a "premium to par" while those trading below 100 are trading at a "discount to par".

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Market Price

The market price of a corporate bond may be above or below the par value, much like buying a concert ticket from a ticket reseller. The face value of the ticket could be £100, but in the secondary market, it can sell for more or less depending on what the market is willing to pay for it.

The price is affected by several factors, including:

• The maturity

• The credit rating of the company issuing the corporate bond

• The general level of interest rates

• The markets’ perception of the issuer’s credit quality

Corporate bonds are typically riskier than government bonds of similar maturities. This divergence creates a credit spread between corporates and government bonds so that the corporate bond investor earns extra yield by taking on greater risk.

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Maturity Date

The "maturity date" is the date upon which the borrowing company is due to repay their corporate bond. Maturities may be short, intermediate or long term:

• Short-term (up to five years)

• Intermediate-term (with maturities ranging between five and 12 years)

• Long-term (greater than 12 years)

Some investors use the visibility of cash flows (fixed interest payment & maturity dates) to match their obligations to when they expect to receive payment from their corporate bonds. For example, they may time their maturities to coincide with school fees.

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Types & Ratings

There are many types of corporate bond which vary in terms of structure of risk.

Before they are issued, most are given a credit rating by one of the three main rating agencies: Standard & Poor’s (S&P), Moody’s or Fitch.

The ratings give investors an idea of how risky the investments are, reflecting an issuer’s capacity to meet its payment obligations.

The best possible rating is AAA from S&P and Fitch and Aaa from Moody’s, indicating that the issuer is extremely likely to meet its financial commitments. As an aside, the British Government has a rating of AA.

There are two main categories of risks, investment grade and high yield.

Investment Grade

Any rating of BBB- or higher from S&P or Baa3 from Moody’s represents an ‘investment grade’ corporate bond, suggesting that the issuer is in a relatively strong financial position.

High Yield

High yield corporate bonds have a rating of or below BB+ from S&P and Fitch and Ba1 from Moody’s. They pay a higher rate of interest to compensate investors for the higher level of risk.

High yield corporate bonds have performed well over the last 20 years.

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Corporate bond Security and Seniority

Corporate bonds can vary in risk based on their claims to collateral and relative seniority. While equity is always subordinate to debt, different debts will have different rankings in relation to the ordering of payments during bankruptcy.

Security

"Secured bonds" have charges over the assets of the company including property, equipment, cash, and intellectual property. In the event of a bankruptcy the assets will be liquidated to repay secured claims, unsecured bondholders will only be repaid if there is residual value.

Seniority

Seniority is an important concept which is often included in the name of the corporate bond itself. Seniority relates to an ordering of payments, all else being equal, senior bondholders are repaid prior to junior bondholders.

Seniority and security provide a good starting point for understanding how debt claims differ. Corporate bonds well secured by collateral and relatively senior to other debts will carry lower interest rates. While, junior, unsecured bonds often have double digit returns to compensate for their equity-esque risk.

On WiseAlpha you will come across a number of terms concerning security and seniority.

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Senior Secured

"Senior Secured" is market convention terminology that means a corporate bond has a first ranking charge over substantially all of the assets of the company including property, equipment, cash, and intellectual property.

This means that if for any reason security over the company is enforced by lenders, senior secured bondholders will receive proceeds with priority to any junior or subordinated debt holders and until the principal amount of the senior secured loan or corporate bond has been repaid.

Senior Unsecured

These corporate bonds aren’t secured against the issuing company’s assets, but you still rank ahead of other unsecured bondholders.

Unsecured

Corporate bonds which do not have charges or security granted over the assets of a company or individual and which rank behind the claims of senior creditors.

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More Complex Bonds

Most corporate bonds are simple but there are a few which can be slightly different.

Perpetual Bonds

A perpetual bond is a security with no maturity date. However, borrowers will have the option to buy back and repay investors at predetermined "call dates". In the absence of a defined maturity, yields on perpetuals are given to the next call date, the "Yield to Call" (YTC).

Contingent Convertible Bonds

A contingent convertible corporate bond (CoCo) is a fixed-income instrument issued by banks and insurance companies that is convertible into equity if a pre-specified trigger event occurs.

Callable Bonds

Callable bonds give the issuer the option to buy back & repay prior to their maturity date. Companies who prepay may be subject to a prepayment premium or fee, call premiums are set out in a call schedule.

For example, a corporate bond issued in July 2018 at a par value of £100 has a call schedule of:

14 Jul 2019 at 102.5

14 Jul 2020 at 101.25

14 Jul 2021 at 100

The issuer has the option to buy back the corporate bonds after July 2019 at 102.5 pence on the pound, a 2.5% call premium. After July 2020, 101.25 on the pound and finally after July 2021 at 100 pence on the pound (at par).

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