Corporate Bonds: Know Your Borrower

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Corporate bonds are loans issued by corporations to pay for their operations, acquisitions, or expenditures. When a company wants to raise funds, it can sell a part of the business by issuing equity shares (stocks) or it can arrange a loan by issuing debt securities (bonds). Corporate bond structures, coupons, credit quality, and maturity dates differ between issuers. Bondholders are lenders to the issuing corporation so, when you buy corporate bonds, it’s important to know your borrower. In the event of bankruptcy, bondholders receive their money before stockholders.

Corporate bond maturity rates range from short-term commercial paper maturing in less than 270 days to 30 years. Bondholders receive predetermined coupon interest payments that are fixed when the bond is issued. These interest payments are taxable, and corporate bondholders must pay federal/state income taxes as applicable unless these securities are purchased in a retirement plan. If corporate bonds are sold before maturity at a higher than purchase price, the bondholder pays short or long-term capital gains depending on the holding period.

Corporate Bonds and Credit Quality

Corporate bonds are either investment or non-investment grade according to credit quality. Bonds of non-investment quality issuers are considered high yield or junk bonds. Bondholders receive higher interest on these debt securities because they assume more risk to own them.

Almost all corporate bonds trade over-the-counter (OTC). Bond dealers and broker firms trade via an electronic network or by telephone. To increase trading transparency, the Financial Industry Trading Authority (FINRA) has created a corporate bond trade reporting system (TRACE®) in 2002. TRACE allows individuals to see real-time trading data on almost all corporate bonds in the U.S. market. Before the implementation of TRACE, it was difficult to determine the most active corporate bonds, total volumes, highs/lows, and advance/declines of issues.

Corporate bonds comprise 18 to 20 percent of the U.S. bond market. According to The Wall Street Journal, actively managed bond funds tend to hold more low-yield government bonds and fewer corporate bonds in all maturities when they believe interest rates are rising.

Corporate Bond Structure

Corporate bonds are structured that relate to the issuer’s capital structure. The bond structure determines where the issue ranks in relation to claims on the company’s assets if it later has difficulty meeting its obligations:

  • Secured corporate bonds are senior structured secured debt at the top of the payout structure. Older issues that aren’t secured bonds don’t have seniority. A secured corporate bond issue is backed by issuer collateral that may be sold to repay bondholders if there’s an interest payment or principal default. For instance, the secured bond may be secured by certain corporate capital equipment or real estate that could be sold to pay bondholders.
  • Junior/subordinated bonds are unsecured bond loans. These debt securities aren’t secured by the issuer’s collateral. They’re unsecured debentures that are backed by the issuer’s promise to repay bondholders. Subordinated debt is a type of unsecured debt. These bonds are paid after higher-ranking bonds are paid. Junior bonds that are issued by a business are sometimes referred to as subordinated debt. Junior bondholders’ demand for repayment of their principal is paid only after claims of senior debt bondholders are paid.

Bondholders are paid in the following order: 1) secured/collateralized bondholders; 2) unsecured bondholders; 3) subordinated debt bondholders; 4) preferred stockholders; and 5) common stockholders.

Guaranteed and Insured Corporate Bonds

Other bonds, such as “guaranteed” or “insured” debt securities, are insured by third-party guarantors or insurers. The third party promises to repay the issuer’s interest payments and principal repayments when they’re due if the issuer cannot.

However, the credit of the guarantor or insurer should be considered. An insured or guaranteed bond isn’t automatically considered an investment-grade bond issue.

Corporate Bonds – Convertibles

Convertible bonds are hybrid securities that offer bondholders regular income and an option to convert the bond to common shares at a certain price over a certain period. A convertible bond usually pays a lower coupon interest rate than the issuer’s other debt securities.

If the bond issuer’s common shares rise higher than the conversion price, the convertible bondholder can exercise the option to become a stockholder.

How to Buy Corporate Bonds

If you want to lock in a certain rate on your money for a period of time, investing in corporate bonds might be right for you. Each bond is quoted as a percentage of par (100), and the minimum price per bond is typically USD 1,000. Bonds may be purchased or sold at least than USD 1,000, depending on the coupon rate.

  • Bond prices and interest rates are inversely proportional. That is, if the five-year U.S. Treasury bond index is 5 percent and you own a AAA-rated corporate bond with a 7 percent coupon that matures in five years, your bond trades at a premium to the market.
    If you own a AAA-rated corporate bond with a 4 percent coupon, your bond will trade at a discount to the current market to adjust yield.
  • Corporate bonds pay interest at a fixed rate, floating or variable rate (the coupon adjusts according to current interest rates, inflation, etc.), or zero coupon bond (interest on the bond is paid at maturity). The bond interest rate is determined at issuance and the type of bond structure.
  • Purchase corporate bonds through your broker-dealer or financial adviser.
  • Check corporate bond prices on financial websites like Yahoo! Finance, Google Finance, or FINRA Market Data (Bonds).

To evaluate corporate bonds, consider the issuer’s credit and default risk. Know your borrower as well as possible before buying an interest rate coupon that’s too good to be true. Default risk is very difficult to determine. Corporate liquidity strongly correlates with the issuer’s default risk. Illiquidity of bonds in the secondary market means that the issue trades on an infrequent basis: finding a buyer for the bond could be difficult in the future if you need to sell. Other risks of owning corporate bonds include events such as merger, acquisition, or hostile takeover can impact corporate bond prices.