How do corporate bonds work?
Corporate bonds work as a borrowing mechanism where companies raise funds from investors instead of relying solely on banks. When you invest in a corporate bond, you are effectively lending money to the issuing company for a fixed period. In return, the company commits to paying you regular interest, known as coupon payments, at predetermined intervals.
The bond also has a maturity date, which is when the company repays the original investment amount, called the principal. Interest rates on corporate bonds depend on factors such as the company’s credit rating, financial stability, and prevailing market conditions. Higher-risk companies usually offer higher interest to attract investors.
Corporate bonds are traded in the secondary market, allowing you to exit before maturity if liquidity permits. However, bond prices may fluctuate based on interest rate changes and credit risk perceptions. Understanding these factors helps you assess potential returns and risks before investing in corporate bonds.
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Types of corporate bonds
Investors have various options when it comes to corporate bonds. Some are short-term bonds with maturities of one to five years, while others are long-term bonds with maturities that can extend to 30 years or more. Additionally, there are different types of corporate bonds, such as:
1. Investment-grade bonds
Corporate bonds are categorised based on their creditworthiness, as determined by credit rating agencies. Investment-grade bonds, rated BBB- or higher up to AAA, are issued by financially stable corporations and are generally considered to have a low risk of default on interest and principal payments.
2. High-yield bonds (Junk bonds)
High-yield bonds, commonly referred to as junk bonds, are debt securities issued by corporations perceived to have a higher risk of default compared to investment-grade bonds. Due to the issuer's potential financial instability, there is increased uncertainty regarding the timely payment of interest and principal upon maturity. These bonds typically offer higher interest rates to compensate investors for the elevated credit risk associated with such issuances..
3. Convertible bonds
These bonds give investors the option to convert their bond holdings into a specific number of the company's common shares at a predetermined conversion ratio. They offer the potential for capital appreciation if the company's stock price rises significantly.
4. Callable bonds
Some corporate bonds have a callable feature, allowing the issuing company to redeem the bonds before the scheduled maturity date. This feature benefits the company if interest rates decrease after the bond issuance.
5. Zero-coupon bonds
Unlike traditional bonds that pay periodic interest, zero-coupon bonds do not make regular interest payments. Instead, they are issued at a discount to their face value and grow to reach the face value at maturity, providing investors with a lump sum payment.
Additional read: Stocks vs Bonds
Features of corporate bonds
Corporate bonds have several key benefits and features that make them an attractive investment option for investors:
1. Fixed interest payments
One of the biggest benefits of corporate bonds is the fixed interest payments that investors receive. This provides a steady stream of income for investors and is especially attractive for those looking for a predictable source of income.
2. Diversification
Investing in corporate bonds allows for diversification of investments. Instead of investing in individual companies, investors can invest in a portfolio of bonds, reducing the potential risk of any one bond defaulting.
3. Low risk
Corporate bonds are generally considered a low-risk investment option, as they are backed by the issuing company's creditworthiness and have a lower default risk than high-yield bonds.
4. Principal investment returned
Once the bond matures, investors receive their principal investment back, thereby minimising the risk of losing money.
5. Higher return compared to traditional fixed-income investments
Corporate bonds may offer a higher rate of return than traditional fixed-income investments such as savings accounts and term deposits.
6. Flexibility
Corporate bonds can be sold on the secondary market, providing investors with the flexibility to sell their bonds before the maturity date if they wish to liquidate their investments.
7. Tax benefits
In some cases, corporate bonds may offer tax benefits to investors. For example, some municipal/public sector undertaking bonds are exempt from federal income tax.
Things to know about corporate bonds
Corporate bonds are widely used by companies to raise funds and by investors to earn predictable income. Before you consider them as part of your portfolio, it is important to understand how they function, what influences their returns, and the risks involved. Knowing these basics helps you evaluate whether corporate bonds align with your financial objectives and risk comfort.
- Issuer and purpose: Corporate bonds are issued by companies to finance expansion, refinance existing debt, or meet operational needs. The issuing company commits to repaying the principal at maturity.
- Interest payments: Most corporate bonds offer fixed or floating interest, paid at regular intervals. These payments form the primary source of income for investors.
- Credit risk: Returns depend on the issuer’s financial strength. Bonds from financially stable companies carry lower risk, while weaker issuers offer higher yields to compensate for risk.
- Maturity period: Corporate bonds come with short, medium, or long maturities, affecting interest rates and price sensitivity.
- Market price movement: Bond prices can rise or fall due to changes in interest rates, credit ratings, or market conditions.
- Taxation: Interest income from corporate bonds is taxable as per applicable income tax rules.
- Liquidity: Some corporate bonds trade actively, while others may have limited liquidity in the secondary market.
Why corporations sell bonds?
Corporate bonds serve as a key financing tool for companies looking to raise funds. They are a type of debt instrument that allows businesses to access capital without issuing new shares. By opting for bonds, companies can secure funding while retaining ownership and decision-making control. Compared to equity financing, debt financing is often more cost-effective, making corporate bonds an attractive option for raising capital. This makes it an attractive option for companies seeking to fund specific projects or enhance their overall financial position.
A corporation's creditworthiness plays a pivotal role in determining the terms of its bond issuance. Companies with consistent earnings potential and a strong financial profile can typically secure bonds at more favourable interest rates. In situations where short-term capital is required, corporations may opt to issue commercial paper. This instrument shares similarities with bonds but typically matures within a shorter timeframe.
How corporate bonds are sold ?
Corporate bonds are sold by companies to raise funds from investors through public issues or private placements, offering regular interest payments and fixed maturity returns.
Corporate bonds are typically issued in denominations of Rs. 1,000 and feature a standardized coupon payment structure. To facilitate the sale of bonds, corporations often engage investment banks to underwrite and market the offering to investors.
Investors who purchase corporate bonds receive regular interest payments from the issuer until the bond's maturity. At maturity, investors are entitled to receive the face value of the bond. The interest rate on corporate bonds can be fixed or variable, depending on the underlying economic indicator.
To provide flexibility, corporate bonds may include call provisions, allowing the issuer to redeem the bonds early under certain conditions, such as a significant decline in interest rates.
Investors also have the option to sell their corporate bonds before maturity. The selling price of a bond is influenced by factors such as the time remaining until maturity and prevailing market conditions.
For investors seeking exposure to corporate bonds without the need for individual security selection, bond mutual funds and ETFs offer convenient and diversified investment options.
Check the basics of debentures for beginners
Taxation rules of corporate bond mutual funds
Zero-coupon bonds are taxed based on the holding period. If they are sold within 12 months, the gains or losses are considered short-term and are taxed according to the individual's applicable income tax slab rate. However, if the bonds are held for more than 12 months, the gains or losses are treated as long-term. In this case, long-term capital gains (LTCG) are taxed at a flat rate of 12.5% without the benefit of indexation.
Example of corporate bonds
Let us understand this with an example.
To start investing in corporate bonds, investor X approaches the stockbroker and opens a Demat account with them. The account opening process involves providing the necessary documents like identity proof, address proof, and PAN card details.
After opening Demat account, investor X comes across ABC Pharmaceuticals Ltd., a well-established pharmaceutical company in India, offering company bonds. The company has a strong track record of financial stability and a credit rating indicating a low risk of default.
ABC Pharmaceuticals Ltd. is issuing bonds with a face value of Rs. 1,000 each. The bond has a coupon rate of 7% and a maturity period of 5 years. This implies that if investor X invests in one bond, he will receive Rs. 70 (7% of Rs. 1,000) as interest income annually for five years.
Impressed by ABC Pharmaceuticals Ltd.'s financial stability and the attractive coupon rate, investor X decides to invest Rs. 1,00,000 in their corporate bonds. With Bajaj Financial Securities Limited, he places an order to buy 100 bonds of ABC Pharmaceuticals Ltd., totalling Rs. 1,00,000 (100 bonds x Rs. 1,000 face value).
As he holds the ABC Pharmaceuticals Ltd. bonds, he receives interest payments of Rs. 7,000 annually (100 bonds x Rs.70 interest per bond) for the next five years. These interest payments are credited to his bank account, which is mapped with the Demat account. At the end of the 5-year maturity period, he will receive the face value of the bonds, Rs. 1,00,000 (100 bonds x Rs. 1,000 face value) back.
Conclusion
Corporate bonds are a popular type of debt financing instrument used by public and private corporations to raise funds for their expansion and growth without giving up ownership. Risk-averse investors seeking portfolio diversification and a steady source of income can invest in company bonds. While these bonds offer higher yields than conventional fixed-income investments like FDs, they are also riskier. Therefore, investors should thoroughly review the credit rating of the company before investing to balance risk and return.
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