Corporate bonds, also known as business bonds, are a common way for companies to raise capital at a more favourable rate than if they were to issue stock. Learn who issues bonds and how they can be used to raise money.
At its core, a bond is a corporate IOU. Investors who buy corporate bonds are in effect lending money to the company they buy them from. The company, or bond issuer, promises to pay back the cost of the bond plus interest when the bond falls due or matures.
A bond is mutually beneficial to both the issuer and the investor. The company makes a pre-established number of regular payments with either a fixed or variable rate of interest. These interest payments are known as a ‘coupon’. The coupon rate is an annual sum expressed as a percentage of the bond’s par, or face, value. So, a business bond with a face value of £1000 that pays an annual coupon of £75 per year has a coupon rate of 7.5%.
Bonds enable companies to acquire the investment they need to finance new projects and facilitate capital expenditure.
Who issues bonds?
Bonds are issued by companies and purchased by investors. In purchasing a bond the buyer (or bondholder) essentially lends money to the company (bond issuer). There is a hierarchy in terms of risk with bonds.
Government bonds are seen as more secure than corporate bonds. Because corporate bonds are deemed riskier they often carry higher interest rates, even for companies with strong credit ratings because there is an increased risk of default.
- Corporate bonds are a way for companies to raise money for investment or capital projects.
- Bondholders (buyers) lend the money to the bond issuer (company). The company agrees to pay interest on the bond and repay the initial investment when the bond reaches its maturity date and expires.
- Bond prices are largely dictated by supply and demand, although as interest rates rise, bond prices tend to fall.
- Bonds may have a fixed interest rate or a floating rate depending on different economic factors.
Different types of bonds and their features
Business bonds are not the only type of bonds that investors can find on the market. There are several others, each with its own risk to reward ratios. The main types of bonds traded in the UK are:
Corporate bonds are specifically bonds issued by businesses to raise money for operations, capital investment and fund projects such as expansion. They are a debt obligation where the person buying a bond agrees to lend the money to the business while the business in return makes a legal agreement to pay interest on the value of the bond and to repay the face value of the bond when it matures.
Bonds can be classified according to their maturity - short term (up to five years) , medium term (five to 12 years) and long term (more than 12 years). Longer term bonds typically offer higher interest rates but may also carry additional risks.
Corporate bonds can also be categorised into two classes:
Investment grade - high level of credit quality, smaller degree of investment risk, lower interest yields
Speculative grade - lower grade of credit quality, often issued by newer companies in competitive or volatile markets, higher default risk which is compensated for with higher interest rates
Government bonds (gilts)
Aside from business bonds, government bonds or gilts are one of the most common instruments on the bond market. Gilts are a fixed-income form of security and are considered very low risk. Many see them as an alternative to cash savings, potentially yielding greater rewards while still very low in risk.
Investors can purchase UK government bonds, or buy overseas government bonds. Keep in mind, however, that investments in some governments are riskier than others.
Agency bonds are issued in the US by government-backed enterprises or by government departments other than the US Treasury. They provide investors with an opportunity for higher returns than government bonds but with only slightly more risk.
Municipal bonds are similar to government bonds. They are often used by local governments and non-profit organisations to fund infrastructure projects like public transport, water systems or utilities.
One of the more divisive financial instruments, junk bonds are potentially high-yield but come at a very high risk. Junk bonds are issued by companies with poor credit ratings or that are experiencing financial hardship. As such, yield-to-maturity rates are often higher, but there is a risk that the company will not be able to meet the bond’s requirements.
Bond categories and varieties
A zero-coupon bond, also known as an accrual bond, is one which doesn’t offer interest payments but trades at a considerable discount. An investor will make a profit at maturity when the bond is realised for its full face value.
This type of bond is a fixed income bond yielding regular interest payments but at certain points in its life cycle it can be converted into a set amount of common stock or equity shares at the discretion of the bond holder.
Callable bonds (also known as redeemable bonds) can be redeemed by the issuer before they have reached their maturity date. Issuers may do this if, for instance, market interest rates fall and it is cheaper to pay off their debt early and re-borrow.
This type of bond gives the investor the option to demand repayment of the principal amount before maturity. It protects the bond holder who may choose to do this if interest rates rise, making future coupon payments less valuable. The investor can then buy higher yield bonds elsewhere.
How bonds are priced and valued
Bonds are calculated via a discounted cash flow analysis that gives the present, theoretical fair value of the bond. This is the present value of the future stream of cash flows the bond is expected to generate.
Factors affecting bond prices and rates
The main factors affecting bond pricing are supply and demand, term to maturity and credit quality. Bonds will trade at a premium (higher than face value), at face value, or at a discount (lower than face value). Interest rate payments are fixed so lower priced bonds will generally have higher yields.
For example, a bond with a face value of £1,000 may have a fixed annual interest payment of 5% or £50 a year. But if that bond is trading at £800, then the present yield is 6.25%.
Yield-to-maturity (YTM) and its significance
The YTM is the total rate of return a bond will make when it makes all interest repayments and pays back the principal amount. Also referred to as a book yield or redemption yield it is considered a more accurate and thorough means of calculating the return from a bond than the current yield which is based solely upon its coupon rate and current market price.
Examples of bonds
Company X issues a ten-year bond with a face value of £10,000 and a coupon rate of 5%. The investor receives an annual payment of £500, or 5%. At the end of the ten-year period the company repays the initial £10,000 capital.
Company Z issues a two-year £1,000 bond with a variable rate of 5%, the rate at time of issue. The annual yield is £50 the first year. In the second year however, the rate drops to 3% so the yield is £30.
Bonds vs stocks: What’s the difference?
Companies may either issue bonds or stocks when they need to raise capital. But what’s the difference for investors?
Primarily, a bondholder is effectively lending capital to the company. A stockholder, however, is purchasing a share of the company. An investor that buys a bond is paid in interest, while an investor who buys a share is paid a dividend in line with the company’s profits. A bond investor will receive the same interest payments regardless of how profitable a company becomes. For a stock investor, as the company’s profitability rises and falls, so does the value of the investor’s stake and therefore the dividend they receive.
Bonds vs loans: understanding the differences
Bonds are often used to generate capital alongside other debt instruments like loans. Bonds are often seen as advantageous because the company can use the money in its operations however it sees fit, without the restrictions and conditions that are often stipulated by banks when issuing loans.
Frequently asked questions about corporate bonds
What are bond funds?
Bond funds are pools of capital from multiple investors that are invested in a number of different types of bonds. A bond fund will often contain a combination of corporate, government and municipal bonds. Bond funds are professionally managed and can be tailored to meet investors’ specific goals.
Where can I buy bonds?
They can be bought through the UK’s Debt Management Office or various trading platforms such as Hargreaves Lansdown and AJ Bell. You can also purchase through investment funds which hold a portfolio of bonds.
What is a risk of default?
Also known, as credit risk, this is the chance of the bond issuer failing to meet their obligations under the bond.