Corporate Bonds

Definition

Corporate bonds are debt securities issued by corporations to raise capital for various purposes such as expansion, acquisitions, or refinancing existing debt. These bonds represent a loan made by an investor to the issuing corporation, and in return, the corporation agrees to pay periodic interest and return the principal amount at maturity. Understanding corporate bonds is essential for evaluating a company's financial health and investment potential.

5 Must Know Facts For Your Next Test

1. Corporate bonds typically have maturities ranging from 1 to 30 years, with longer maturities generally offering higher yields to compensate for increased risk.
2. They can be secured or unsecured; secured bonds are backed by specific assets of the company, while unsecured bonds are not and may carry higher risk.
3. Interest on corporate bonds is usually paid semi-annually, and the bondholder receives the principal amount back when the bond matures.
4. The market price of corporate bonds can fluctuate based on changes in interest rates, credit ratings, and overall market conditions.
5. Investors must assess the issuer's credit risk as a lower credit rating often results in higher yields due to perceived risk of default.

Review Questions

• How do corporate bonds differ from government bonds in terms of risk and return?
  • Corporate bonds generally carry more risk than government bonds because they are subject to the financial health of the issuing company. While government bonds are backed by the full faith and credit of the issuing government, corporate bonds depend on the issuer's ability to generate revenue and repay debt. As a result, corporate bonds typically offer higher yields than government bonds to compensate investors for this added risk.
• Evaluate how changes in interest rates impact the valuation of corporate bonds and their yield measures.
  • When interest rates rise, the market value of existing corporate bonds tends to fall because new bonds are issued at higher rates, making older bonds less attractive. Conversely, when interest rates decline, existing corporate bonds with higher coupon rates become more valuable. This inverse relationship affects yield measures such as yield to maturity and current yield, as investors reassess their returns based on prevailing interest rates in the market.
• Analyze the implications of a downgrade in a corporation's credit rating on its outstanding corporate bonds.
  • A downgrade in a corporation's credit rating typically signals increased risk of default, which can lead to a decline in the market price of its outstanding corporate bonds. Investors may demand higher yields to compensate for this increased risk, resulting in wider spreads compared to benchmark rates. Additionally, companies may face challenges in issuing new debt at favorable terms as potential investors become wary of investing in lower-rated securities. This can affect the corporation's cost of capital and overall financial stability.

Related terms

Yield to Maturity: The total return anticipated on a bond if held until it matures, taking into account the bond's current market price, coupon payments, and time to maturity.

Coupon Rate: The annual interest rate paid by the bond issuer based on the bond's face value, typically expressed as a percentage.

Credit Rating: An evaluation of the creditworthiness of a borrower, typically expressed as a letter grade by rating agencies, indicating the likelihood of default on debt obligations.