What are Corporate Bonds?
Corporate Bonds are fixed income securities issued by corporations with promised fixed payments in a periodic manner. These fixed payments are again segregated into two components, namely the coupon and the notional or face value. When a corporate bond is issued by the organization, the organization accepts the fixed amount from the investors at an issue price, which may be more or less than the notional depending on the market conditions. When the issue amount determined by the issue price is greater than the national, the bonds are said to be trading at a premium, and the vice-versa phenomena are considered as a discount bondDiscount BondA discount bond is one that is issued for less than its face value. It also refers to bonds whose coupon rates are lower than the market interest rate and thus trade for less than their face value in the secondary market.. Corporate bonds are listed into different types based on the riskiness and the terms of the bond.
List of Top 5 Types of Corporate Bonds
Below is the list of the most common types of Corporate Bonds
#1 – Senior Bonds
These bonds guarantee a preliminary claim to the investors on the company’s assets should the company go out of business. In other words, the holders of senior bonds receive payments even before the shareholders are paid.
#2 – Senior Secured
These secured bondsSecured BondsA secured bond is when the bond's issuer provides a specific asset as collateral and offers a reduced interest rate compared to unsecured bonds. In case of default, the issuer is obligated to transfer the title of the collateralized asset to the bondholder. are backed by the issuing organization’s properties or assets, and the investors have a claim on the stated assets or properties. Hence, they are ahead of other lenders in the queue to be repaid.
#3 – Senior Unsecured
These types of corporate bonds are not backed by any guarantee and hence riskier than the senior secured type, but they are less risky than the other unsecured bonds held by the investors down the line in the repayment queue. They stand ahead of the unsecured bondholders in the repayment queue.
#4 – Subordinated
This type of subordinated bondholders receives their payments from the company once the above three bondholders are paid. However, they still receive their payments ahead of other creditors and shareholders.
#5 – Convertible Bonds
These convertible bonds can be converted into a fixed number of a company’s shares at a set price, as mentioned in the bond term sheet. These bonds have dual characteristics of fixed payments for a while, and capital appreciationCapital AppreciationCapital appreciation refers to an increase in the market value of assets relative to their purchase price over a specified time period. Stocks, land, buildings, fixed assets, and other types of owned property are examples of assets. once converted into shares.
Price and Yield to Maturity (YTM) of a Corporate Bond
The price and its corresponding yield of a bondBondA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually. are determined by the following factors.
- Demand for the bond in the market: It is the open interest expressed in the form of a bid and asks prices quoted in the market.
- Ratings are assigned to the bondRatings Are Assigned To The BondBond rating refers to how designated agencies classify fixed income securities in order to help investors identify the security's future potential. After researching the issuer's financial standing, including growth prospects and upcoming corporate actions, ratings are assigned. by credit rating agencies like Moodys, Fitch, and S&P.
- Age of the bond: It denotes the number of years left to maturity. The general price tendency is that its price pulls to the par value (face value) as the maturity is nearing.
The corresponding yield of the bond for the quoted price is the rate that is used to discount the future cash flows such that its value is equal to the current price of the bond. It is calculated through the following formula.
Solving for YTMYTMYield to Maturity refers to the expected returns an investor anticipates after keeping the bond intact till the maturity date. In other words, a bond's expected returns after making all the payments on time throughout the life of a bond. in the above equation gives the Yield to maturity of the bond. YTM assumes a single rate used to discount all the cash flows so that the present value of all the cash flows discounted at YTM gives the current market price of the bond.
Compute the YTM of a 20 year bond of $1000 per value with a 6% coupon rate, which is trading at a price of $ 802.07.
Coupon C = 0.06 * 1000 = 60
802.07 = ∑ t =120 60/ (1+YTM) t + 1000/ (1+YTM) 20
Computing YTM through a trial and error or solver in excelSolver In ExcelA solver is a type of analysis tool that helps find solutions to complex business problems requiring crucial decisions. The goal, variables, and constraints for each situation are first established. The solver then gives an optimal solution that accurately sets the variable's values, meets all conditions, and achieves the goal. gives the result
YTM = 8.019%
Price-Yield Relationship of Corporate Bonds
Price and yields share an inverse relationship with each other in a way that as the price increases, the yield tends to decrease and vice-versa.
The slope of the above graph demonstrates the sensitivity of the bond. This slope is called the effective durationEffective DurationEffective Duration measures the duration of security with options embedded. It helps evaluate the price sensitivity and risk of hybrid securities (bonds and options) to a change in the benchmark yield curve. The modified duration can be called a yield duration. of the bond. In other words, effective duration measures the price sensitivity of the bond to the change in yield. It is defined as the average change in the price of the bondPrice Of The BondThe bond pricing formula calculates the present value of the probable future cash flows, which include coupon payments and the par value, which is the redemption amount at maturity. The yield to maturity (YTM) refers to the rate of interest used to discount future cash flows. for a 1% change in the yield.
The formula for the effective duration is given as follows:
- V– = Value of the bond when the yield is decreased
- V+ = Value of the bond with an increase in yield.
- V0 = Original Value of the bond
- Δy = Change in the yield.
Features of Corporate Bonds
The following are the features of Corporate Bonds.
#1 – The spread of Corporate Bonds
Corporate bonds are usually riskier than the government bonds that are issued by federal governments or local bodies like municipalities etc. Since it is riskier, the return expected by a rational investor is more compared to government bonds, which are reflected in their high YTMs compared to government bonds. The additional yield required by the investor compared to the government bonds is called the spread.
#2 – Embedded Options in a Corporate Bond
Some of the corporate bonds come with call and put features embedded with them as declared by the issuer of the corporate bonds.
A callable bondCallable BondA callable bond is a fixed-rate bond in which the issuing company has the right to repay the face value of the security at a pre-agreed-upon value prior to the bond's maturity. This right is exercised when the market interest rate falls. is redeemed before the maturity of the bond when the price of the bond reaches the call price. A call price is a stated price at which the bond can be called back by the issuer repaying the face value to the investor before maturity. The price of a callable bond is generally low to the comparable non-callable bond because of the risk to the investor that the callable bond can be called well before maturity.
A puttable bond is an embedded option in the bond contract, which renders protection to the investor when the price of the bond goes below the issue price. A buyer of the putable bond is insured to the price decrement of the bond when interest rates rise and hence beneficial to the bondholder. Hence, the price of the putable bond is high compared to the normal straight bond. Therefore, the puttable bond is redeemed at put price even though the bond price goes below the put price before maturity on the put date.
Most organizations prefer corporate bonds to long terms loans for raising money as they offer beneficial features for both investors and borrowers while they are actively traded on the secondary market as well. Therefore, they constitute a strong component of a company’s capital structure.
This has been a guide to Corporate Bonds. Here we discuss the list of top 5 types of Corporate Bonds along with Price- Yield relationship and the maturity of these bonds. Here we also discuss some features of corporate bonds. You can learn more about accounting from the following articles –