How Corporate Bond Works

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What are Corporate Bonds

Corporate Bonds are debt securities wherein the bond issuer makes periodic coupon interest payments to its bondholders and repays the principal amount on its predetermined maturity dates. These bonds are issued by public and private sector companies to raise capital from investors for operations, business expansion, or debt refinancing. 

Corporate bonds having a strong credit rating (AAA to BBB) are considered investment-grade bonds or low risk bonds. Bonds issued by companies rated below investment-grade credit ratings (i.e., rated BB and below) fall under the speculative-grade category. These bonds, also known as high yield bonds, offer higher returns than investment grade bonds to compensate investors for the higher risk involved. Investors should check the credit rating of the bond issuer before investing. The lower the credit rating, the higher the risk of defaults and vice versa. One should invest in bonds according to one’s risk appetite.

How do Corporate Bonds Work

Public and private sector companies issue bonds to raise finances for purchasing equipment, building a new plant, or growing the business. Investors who purchase these corporate bonds become creditors of the company. Note that while corporate bonds act as an IOU for the bond issuing company, its bondholders do not have an ownership interest in the issuer company like its shareholders. Here’s how corporate bonds work:-

• Companies issue bonds in the primary market, wherein an investor can buy bonds directly from the issuer. In a public issue, the issuer invites the general public for border access and private placements are usually offered to a select group of persons (not exceeding 200 as per the Companies Act, 2013). 
• The bonds are then traded in the secondary market, wherein the returns fluctuate based on market interest rate changes and the issuer’s financial health.
• An investor lends a fixed amount, i.e., the principal, to the bond issuing company. The issuer makes periodic coupon interest payments and repays the principal on a predetermined maturity date to the bondholders.
• Investors can choose to hold corporate bonds until maturity or sell their bonds before the maturity date in the secondary market. The selling price of the bond may be lower or higher than the purchase price based on the prevailing market interest rates.

Valuation of Corporate Bonds

The value of corporate bonds rises when interest rates fall, and falls when interest rates rise. The longer the maturity of the bond, the greater the degree of price volatility. Investors can eliminate the interest rate risk by holding a bond until maturity, because an investor will receive the face value of the bond at maturity. The inverse relationship between bonds and interest rates of the corporate bonds can be explained as follows:-

• In the rising interest rates environment, new bond issues come to market with higher yields than older bonds, making those older ones worth less. Hence, the prices of the old bonds fall, making them less attractive.
• When interest rates fall, new bond issues come to market with lower yields compared to older bond issuances, making those older, higher-yielding ones worth more. Hence, their prices go up.
• As a result, if an investor sells a bond before maturity, it may be worth more or less than it was paid for.

How to Invest in Corporate Bonds

Investors can invest in corporate bonds through two routes: during the public issue, i.e., through the primary market, or buy that bond directly from its existing investors through the stock exchange(s) at its market price, i.e., through the secondary market.

Retail investors can purchase and sell corporate bonds through conventional stock brokers and OBPP (Online Bond Platform Providers). Investors can also invest in corporate bonds through Paisabazaar by logging into its app or website. 

FAQs

How do corporate bonds generate returns for investors?

Corporate bonds provide returns through periodic coupon interest payments to bondholders and repayment of principal at maturity. If an investor sells bonds before maturity at a higher price, they may also benefit from capital gains in the secondary market.

Are corporate bonds risky?

Corporate bonds carry credit risk (when the issuer defaults), interest rate risk (the price of the bond falls), prepayment risk (the issuer repays the debt before maturity) and liquidity risk (not having enough trading volumes to sell). 

Can corporate bonds be sold before maturity?

Most listed corporate bonds can be sold in the secondary market, i.e., NSE or BSE, before maturity. However, the liquidity of the bond varies. The selling price depends on credit rating changes, interest rates, and market demand.