How Corporate Bonds Work: A Beginner’s Guide

Corporate bonds offer investors an opportunity to earn a fixed income regularly while preserving capital at the same time. Understanding how they work is crucial, whether you are seeking stability or potentially higher returns. The blog covers corporate bonds, their types, benefits and risks involved and how you can consider them to diversify your portfolio and generate a steady income.

What Are Corporate Bonds?

Corporate bonds are debt securities issued by companies to raise capital from investors. Investors lend money to the company, which agrees to pay interest over a specified duration and to repay the principal amount at the time of maturity. These bonds may be classified into high-yield or investment-grade, depending on their creditworthiness. 

This is assessed by credit rating agencies, which assign a particular rating to the bond, indicating potential default risks. Bonds with high credit ratings (AAA, BBB, AA) are usually considered to be investment-grade, while those with lower ratings, like BB and below, are considered high-yield or junk bonds. 

How Do Corporate Bonds Work?

This is how corporate bonds work: 

• Purpose & Issuance
  Companies issue bonds to raise capital for various reasons, such as funding new projects, refinancing debt, and expansion, among others. Investors become creditors of the company and not owners (like shareholders). 
• Major Aspects
  These include the face value (the principal amount promised to be repaid at maturity), maturity date, coupon rate (the fixed interest rate paid to bondholders, usually semi-annually or annually), and yield to maturity (the total return investors may expect if they hold the bond till the maturity date). 
• Returns & Risks
  You should account for credit risks (company defaulting on its debt obligations), interest rate risks (changes in market interest rates impacting the bond price), among other risks. There is also the question of higher-rated (better credit quality but lower yields) and lower-rated (lower credit quality but higher yields) bonds to consider. 
• Liquidity and Trading
  Corporate bonds can be traded on organised exchanges, and prices fluctuate, depending on market interest rates, company performance, and credit ratings. When interest rates increase, the bond prices usually decline and vice versa.
• Investment Aspects
  You can invest in these bonds to diversify your portfolio while earning fixed income via interest payments. However, it would be wise to keep your risk appetite in mind while investing in these bonds, since they may be riskier than Government bonds. 

Key Components of a Corporate Bond

Here is a detailed explanation of corporate bonds, taking all the key components into account - 

• Face Value
  The principal amount that you will receive at maturity. It is usually a fixed amount. 
• Coupon Rate
  It is the fixed annual/semi-annual interest rate paid on the face value of the bond. 
• Maturity Date
  It is the date on which the issuer will repay the face value of the bond. Maturity dates can vary anywhere from less than 3 years to more than 10 years. 
• Yield
  It is the overall return you can expect on the bond. Several aspects, such as the time to maturity, bond price, coupon rate, and credit rating of the issuer, influence the yield. There are various kinds of yields, including the YTM (yield to maturity), current yield, and the yield to call (YTC). 
• Credit Rating
  They are assigned by the credit rating agency to evaluate the creditworthiness of the bond and its issuer. Higher credit ratings, like AA or AAA, indicate lower default risks, while lower credit ratings, like B or C, may indicate higher risks of default. 

Types of Corporate Bonds

There are several types of corporate bonds. They are -

• Investment-grade Bonds
  They are safer and have higher credit ratings, indicating a lower risk of defaults. However, they usually come with lower yields and are issued by entities that have better financial health and a solid track record. 
• High-yield/Junk Bonds
  These are bonds with lower credit ratings, indicating a higher chance of default. They are typically issued by companies that are not as financially sound. However, they may provide higher interest rates to compensate for the increased risks. 
• Convertible Bonds
  They are bonds that can be converted into shares of the issuer’s common stock at the bondholder’s discretion. It offers potential for capital appreciation in case the stock price of the company goes up. 
• Callable Bonds
  In this case, issuers are allowed to redeem their bonds prior to their scheduled maturity date. Issuers usually call the bonds in case the interest rates have come down, allowing them to refinance debt at a lower cost. 
• Secured Bonds
  The issuing company secures these bonds with assets like equipment, real estate, and other collateral. 
• Unsecured Bonds
  These are bonds which are not supported by any underlying assets. 
• Zero-Coupon Bonds
  These bonds do not pay any periodic interest payments. They are issued at a discount to their face value. The investors get the face value at the time of maturity. 
• Step-Up Coupon Bonds
  These bonds come with a coupon rate that goes up at a predetermined interval over a period of time. The first coupon rate is usually lower than the market interest rate, although it can rise over time. 
• Income Bonds
  Interest is paid by these bonds only if the company is profitable. They are issued by entities with lower credit ratings that are facing issues in making their interest payments. 

How to Invest in Corporate Bonds

To invest in corporate bonds, here are a few key things you need to consider -

• Understand your investment objective
  Decide on your specific investment goals, i.e. whether you want capital appreciation and long-term growth or regular income. This will help you choose the right type of bond. 
• Evaluate your risk appetite
  High-yield bonds come with increased default risks, while investment-grade bonds come with lower returns but are safer choices. 
• Compare and assess the available funds
  Compare multiple funds based on key parameters such as yield, duration, credit quality, expense ratio, and fund performance. 
• Diversifying your investment portfolio
  Avoid staking all your bets on a single corporate bond. Diversify investments between corporate and Government bonds, along with stocks and other options to balance risks and rewards. 
• Track your investment
  Once you make your investment, track the bond performance and conditions. Be prepared to tweak your portfolio, since interest rate fluctuations and credit quality changes may affect the investment. 

Benefits of Investing in Corporate Bonds

Here are the key benefits of investing in corporate bonds: 

• Higher Interest Earnings
  Corporate bonds usually offer higher returns in comparison to Government bonds, which could help you scale up your future earnings. 
• Lower Risks
  It is important that you analyse the potential risks associated with your investment. However, corporate bonds could have lower risks since the inflation rate does not impact them as much. 
• Rewards
  These bonds are usually considered investments for shorter investment durations. Since the maturity period starts from less than three years, it will take a comparatively shorter period to get a return on your investment. 
• Tax Benefits
  Based on your tax segment, you are required to pay short-term capital gains (STCG) if you hold the bond for less than three years. Section 112 is applicable to those where the holding period is more than 3 years. A rate of 20% is applied to your LTCG (long-term capital gains). 
• Professional Management and Liquidity
  These bonds are usually managed by professionals who make decisions based on extensive research and market conditions. They also ensure higher liquidity, enabling you to purchase or sell shares at the current NAV (net asset value). 

Risks Associated with Corporate Bonds

There are several risks associated with corporate bonds that you should be aware of. These include: 

1. Credit Risks - They indicate the risk of defaults by the issuer of the bond.
2. Market Risks - Risks associated with changing market conditions and economic developments
3. Liquidity Risks - Associated with bonds that could be hard to sell swiftly at no loss
4. Call Risks - Here, the yield-to-maturity framework could be impacted if the issuer redeems the bond early

Corporate Bonds vs. Government Bonds

Here is a closer look at the major differences between Corporate and Government bonds. 

 Read More: Differences between Corporate Bonds and Government Bonds