Corporate bonds refer to the debt securities that are issued by private and public entities. They are issued to raise funds for a variety of purposes, such as continuing operations, Mergers, and acquisitions, or to grow their business. These debt instruments often have a maturity of at least 1 year. Debt is a better alternative since it will not directly impact the company’s shareholders, so most organizations tend to issue debt instruments to raise funds for their operations.
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What are Corporate Bonds?
A corporate bond is a type of debt security that is issued by a company and sold to investors. The company which issues the bonds get capital invested by the investors and in return, the company gives interest with a fixed or variable rate which is predecided in the bond indenture. This fixed or variable rate is known as the coupon and these coupon payments are usually made twice a year. When the bond reaches maturity the payment ceases and the original investment which is also known as “principal,” is returned to the investors. The ability of the bond to repay is seen by the backing of the bond i.e in some cases the bond has some collateral.
How do they work?
Companies issue bonds which are known as corporate bonds to raise money in their business activity. Investors buy that bonds and receive regular interest payments from the issuing company throughout the maturity of the bond. When you invest in a corporate bond you are making a loan to the company, instead of getting an ownership stake, which you get through shares.
Corporate bonds usually have a face value of Rs. 1000 when issued. The amount is repaid upon the ‘maturity date’ when the bond expires. The investors will receive interest payment between the issue date and maturity date. If you invest Rs. 50,000 in a bond and that has a coupon of 10% p.a then you will receive Rs. 5,000 every year until the maturity of that bond.
The bonds are rated according to the risk involved with them. The higher the rating more will be the price of the bond and the less will be the Interest rates & vice-versa. Corporate bonds tend to pay a higher rate of interest compared to Government bonds as they are riskier than government bonds.
The company must, however, display excellent financials to issue corporate bonds. Credit rating agencies issue corporate bond ratings based on various variables such as creditworthiness, market efficiency, track record, and much more, and lenders compare the ratings when purchasing these bonds.
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Merits of Corporate Bonds
- Corporate Bonds have higher growth potential as compared to Government bonds.
- They are less vulnerable to inflation & interest rates than government bonds due to a generally short period of redemption.
- Corporate Bonds are less risky as compared to equity because when the firm dissolves bondholders are given more priority than equity shareholders.
- Also, they are very useful diversified for low-medium, & medium-high risk portfolios.
Demerits of Corporate Bonds
- Corporate Bonds are high risky than government bonds due to the danger of defaulting of the company.
- They may fall in value if the inflation or interest rates rise or due to a severe economic downturn.
- They also have fewer returns than equity in terms of long-run returns.
- If a companies rating falls in between the period of bond then the value of the bond may also fall.
If the investor is looking for a short- to long-term investment fixed income plan but doesn’t want to take too much risk exposure, the safest alternative is corporate bonds. That being said, they should also consider the risks closely before they invest in a corporate bond.
Author – Hariharan Krishnan
About the Author – Hariharan Krishnan is currently in second year BAF and is also doing FRM part 1. He is passionate about financial markets and loves to play chess and outdoor games.