Corporate Bond
A corporate bond is a debt security issued by a corporation to raise capital, in which the issuer promises to pay the bondholder periodic interest and to repay the principal at maturity. Corporate bonds are a major source of financing for companies and a significant asset class for investors. Because they carry the credit risk of the issuing company, corporate bonds offer higher yields than government bonds of comparable maturity.
Definition
A corporate bond is a loan from an investor to a corporation. The corporation receives funds in exchange for a promise to make specified payments over time. The terms of the bond—including the coupon rate, maturity, and any special features—are set out in the bond indenture, a legal contract between the issuer and the bondholders.
Corporate bonds differ from government bonds in that they carry credit risk: the possibility that the issuer will fail to make payments as promised. To compensate investors for this risk, corporate bonds typically offer higher yields than government securities, and the difference in yields—the credit spread—reflects the market's assessment of default risk.
Types of corporate bonds
Corporate bonds come in various forms.
Secured bonds are backed by specific assets of the issuer, which are pledged as collateral. If the issuer defaults, bondholders have a claim on those assets.
Unsecured bonds (debentures) are backed only by the general creditworthiness of the issuer, without specific collateral. They carry higher risk.
Senior bonds have priority over other debt in the event of liquidation; subordinated bonds rank below senior debt.
Fixed-rate bonds pay a fixed coupon; floating-rate notes pay interest tied to a reference rate.
Convertible bonds give the holder the option to convert the bond into shares of the issuer's stock, providing potential upside in exchange for a lower coupon.
Callable bonds allow the issuer to redeem the bond before maturity, typically when interest rates fall.
Zero-coupon corporate bonds pay no periodic interest and are issued at a discount to face value.
Credit ratings
Credit rating agencies assess the creditworthiness of bond issuers. The principal agencies are Moody's, Standard & Poor's, and Fitch. Ratings range from the highest quality to the lowest.
Bonds rated in the higher categories—from AAA to BBB (S&P and Fitch) or Aaa to Baa (Moody's)—are classified as investment grade. Bonds rated below these levels are classified as speculative grade or "high yield" (also called junk bonds). The distinction matters because many institutional investors are restricted to holding investment-grade securities.
Ratings reflect an assessment of the issuer's ability and willingness to meet its obligations, and changes in ratings can significantly affect bond prices.
The corporate bond market
The corporate bond market is one of the largest securities markets in the world. It comprises the primary market, where new bonds are issued—typically through underwriters who market the securities to investors—and the secondary market, where existing bonds are traded, often through dealers or electronic platforms.
The market is segmented by credit quality, sector, and maturity. The investment-grade segment is dominated by large, well-established issuers, while the high-yield segment comprises smaller or more highly leveraged firms.
Determinants of corporate bond yields
The yield on a corporate bond relative to a benchmark government bond reflects several factors.
Credit risk is the primary determinant: the greater the perceived likelihood of default, the higher the required yield.
Liquidity affects yields: less liquid bonds require higher yields to compensate investors for the difficulty of selling them.
Tax treatment can influence yields: for example, bonds whose interest is tax-exempt may offer lower yields.
Maturity affects yields: longer-term bonds typically carry higher yields, reflecting the greater uncertainty over a longer horizon.
Market conditions, including the level of interest rates and the availability of credit, affect the overall level of corporate bond yields.
Risks facing corporate bondholders
Corporate bondholders face several risks.
Credit risk (default risk) is the possibility that the issuer will fail to pay interest or principal. It is assessed by credit ratings and reflected in the credit spread.
Interest rate risk is the risk that rising interest rates will reduce the market value of the bonds.
Liquidity risk is the risk that a bond cannot be sold quickly at a fair price.
Reinvestment risk is the risk that coupons and principal will have to be reinvested at lower rates.
Call risk is the risk that the issuer will redeem a callable bond when interest rates fall, forcing the investor to reinvest at lower rates.
Inflation risk is the risk that inflation will erode the real value of fixed payments.
The role in the economy
Corporate bonds play an important role in the economy. They provide firms with access to long-term finance, complementing bank loans and equity. They give investors a means of earning returns while taking on credit risk. They contribute to the development of capital markets, particularly in economies where bank financing is limited. The corporate bond market also provides information about the health of firms and sectors, since credit spreads reflect market assessments of risk.