Corporate Bonds

Bonds issued by companies are known as company or corporate bonds. A bond is a form of debt issued by companies (corporate bonds) to raise money. In other words, they are loan stock, or “IOUs” and used as investment options.

If you buy a bond, you are, in effect, lending money to company (the bond issuer). In return, the company promises to pay you a set rate of interest each year (this payment is known as a coupon) and to repay your capital at a set date in the future, known as the redemption date.

Unlike equities, ownership of corporate bonds does not signify an ownership interest in the company that has issued the bond. Instead, the company pays the investor a rate of interest over a period of time and repays the principal at the maturity date established at the time of the bond’s issue.

Depending on how far in the future this date is set, corporate bonds can be short term investments, medium term investments, or long term investments.

The interest rate on a corporate bond reflects how much risk you are taking. So a corporate bond from a large, financially stable company is likely to pay a lower rate of interest. Bonds have different ratings, from financially stable to risky.

Some companies that are struggling or in financial difficulty will pay a high rate of interest on their bonds in order to attract investors. These are known as junk bonds because there is a high risk of you not getting your money back if the company collapses.

Why do company issue corporate bonds?

Corporate bonds are an important tool in a company’s arsenal when it comes to raising capital. Companies issue bonds to raise funds for a wide variety of purposes, including:

• Buying capital equipment or property
• Funding research and development
• Refinancing debt
• Buying back issued shares from shareholders
• Paying dividends on existing shares
• Financing mergers and acquisitions

The issuing company may find more favourable conditions in the bond market than they would through traditionally lending channels, like banks.

How corporate bonds work?

To understand the characteristics and return of a bond investment, let’s look at a simple example. Say you want to buy a corporate bond for £1000 with a maturity of 10 years, paying a 4% regular coupon. This is what your cash flows will look like:

• You pay the corporate £1000 for the bond – this is its face value
• Each year you will get £40 in interest for holding the bond
• After 10 years, you will get your principal £1000 back
• At maturity you will have £1400 from the bond; the £1000 you originally lent and £40 profit from the interest payments.

You’ll hear yield mentioned a lot in relation to bonds; this is just another way of saying the income return and is usually expressed as a percentage of the price. Yields have an inverse relationship with the price of a bond. As bond prices fall, yields will rise, and vice versa.