Government-issued bonds offer both a sense of security and predictable returns. Corporate bonds, however, give investors greater yield for their principal investment without the same assurance that government bonds provide. This yield, of course, depends on the investor’s choice of bond issuer and the issuing company’s ability to make good on its promises.
It is important to understand what corporate bonds are, the risks involved when investing in them and how they work. We explain below.
What are corporate bonds?
A corporate bond is a debt security that corporate entities issue to entice investors. The bond functions like an I.O.U. because the bond issuer promises bondholders steady interest payments for a fixed period and full payment of the debt upon maturity.
The bond market has its own language. Here are the most important terminologies to know before investing:
Bond certificate: A literal I.O.U. The bond certificate is a printed document that indicates the details of the bond (coupon, par, maturity, interest payment schedule), as well as the bond issuer’s name.
Bond issuer: The company that issues the bonds or ‘borrows money’ from investors. In return for purchasing the bond, companies legally commit to pay their debt, including interest, to the investors when the bond matures. Companies that are deemed high-risk issuers, based on their credit rating, usually promise higher interest rates to attract investors.
Bondholder: The investor who purchases the bond or ‘lends money’ to the company. Bondholders are considered creditors.
Corporate bond: A fancy I.O.U. issued by corporate entities. Companies issue bonds as a way to raise money for their endeavours. Investors who purchase the bond are, in essence, lenders to the issuing companies.
Unlike stocks, bondholders do not become part-owners of a company and do not acquire rights to profits through dividends.
Coupon: The interest rate of the bond. The actual interest payment bondholders will receive from bond issuers are computed from the bond’s par or face value.
Face value or Par: The amount bond issuers pays the bondholder upon maturity. This amount does not change—unlike the bond’s market value, which may increase or decrease based on inflation and the market’s performance.
For instance, a $2,000 principal investment for a 10-year bond issued with $1,000 par and five per cent coupon translates to the following:
- The investor purchased two $1,000 bonds.
- The amount bondholders should expect for each bond annually is $1,000 x 0.05 or $50.
- With a semi-annual payout, bondholders will receive $25 twice a year or $12.5 for a quarterly payout (both equal to $50).
- Fast forward to 10 years later, the company will pay bondholders two $1,000 par along with the last coupon payments regardless of the bond’s market value at the time of maturity.
Indenture agreement: An indenture agreement outlines the terms and conditions and calculations used to arrive at the amount bondholders should expect. Bondholders should read and understand the indenture agreement like any legally binding contract, so they know how their money would grow over time and how much and when to expect interest payments.
Maturity: A bond’s maturity is the length of time a company assures they can pay off their debt. For example, a bond with a 10-year maturity simply means that investor can expect their invested money back in full after 10 years.
Maturity may be short, intermediate or long-term. Investors should consider how interest and inflation rates could affect their payout. Since different bonds have different maturities, it’s better to study the company’s offer first before making a commitment.
Note: Notes are bonds that mature in less than 10 years.
Principal: The amount that the investor lends to the company. This means an investor who purchased a bond for $2,000 has a principal of $2,000.
Prospectus: This is basically a brochure that bond issuers provide potential investors as part of their ‘sales talk’. These documents usually include financial statements, the strategies to be used, how the money will be used, company background and potential risks to buyers, among others.
It is highly advised that potential bondholders read the prospectus so they can make informed decisions.
Advantages of corporate bonds
Here are some reasons why investing in corporate bonds could give portfolios an advantage:
Assured returns with a credible company
Companies are legally bound to pay their debts to bondholders upon maturity, which means an investor who lends their money to a credible company is assured of regular interest payments each year. This assurance also means that the money they lend will come back to them in full.
Bonds are more stable than shares
Both the bond and stock markets are affected by economic downturns and inflation rates, but there is more assurance that an investor will actually receive money from bonds. Compared to bonds, earnings from shares depend on the stock’s current market price which may not assure a positive income.
Bonds have ‘contracts’
Since indenture agreements exist for corporate bonds, bondholders know what they are getting into and the options they have if they plan to either sell early or hold the bond to maturity.
Bondholders have seniority over shareholders
In case a company defaults or goes bankrupt during the bond’s term, companies are required to address debts first before paying the owners.
This means if a company has enough money left to pay their debts after selling its assets—as required by law—bondholders could get a portion of, if not their full, principal investment. Shareholders, as part-owners, will only be paid if there’s any extra. In most cases, however, money runs out after paying lenders and taxes.
Disadvantages of corporate bonds
Corporate bonds are not always as secure as government bonds and lenders, such as bondholders, take risks in allowing issuers to use their money. Other disadvantages include:
Assured but fixed returns only
A company is not legally obligated to pay its creditors more than what has been agreed on, which means the investors only receive what they signed up for. This could also be less if one considers rising inflation rates.
Bonds have contracts
Indenture agreements limit the actions bondholders can take according to its terms and conditions. For instance, a bondholder may decide to sell two years into the 10-year bond because they sense trouble in the company but the indenture agreement could prevent them from doing so.
Bonds are affected by rising inflation and interest rates
Bondholders may find that they receive less for their principal investment because of inflation, especially when interest rates rise.
A company may also issue another set of bonds with a higher interest rate to keep up with market movements, but the interest rates of previously purchased bonds do not change.
For instance, an investor is in their 3rd year of holding a 10-year bond with $500 par and 4 per cent coupon when the market suddenly changed. The same company may issue a new set of 10-year bonds with $500 at 7 per cent coupon.
The first batch of bondholders would then earn less for their principal investment than the second batch and, with inflation rates rising, their return on investment would have a weaker purchasing power. If the first batch decides to sell their bonds, they will only be able to sell it with the same package it was purchased, which isn’t really an attractive purchase compared to the newer bonds.
Corporate bond options
There are simple and complex types of corporate bonds, depending on its features and the terms surrounding the bond agreement. Simple bonds are straightforward and offer more security. Complex bonds, like inflation-linked bonds, offer more flexibility but have more conditions for bond issuers.
Potential investors may shop for corporate bonds in the Australian bond market based on their security, maturity and terms or payment of interest rate.
The differences are explained below:
Security: Corporate issued bonds may either be secured or unsecured. Its main difference is that secured bonds are backed by either of the two:
- a third-party who pledges to pay off whatever the issuer can’t meet when the bond matures; or,
- a collateral in the form of a specific asset the bond issuer owns.
Unsecured bonds have neither.
Maturity and term: Bonds are identified based on the duration of the bond contract. Companies may either identify the bond according to when it will mature or based on the length of its term. Some bonds have lifespans exceeding 10 years in foreign bond markets, but corporate bonds in Australia usually fall under any of the following:
- Short-term bonds have a 1-year maturity period.
- Medium-term bonds mature anytime from one to three years.
- Long-term bonds take more than three years to mature.
Interest and payment: Companies may issue bonds that have either fixed or floating interest rates and it may be paid out regularly or as a zero-coupon bond.
- The previous sections in this article describe fixed-rate bonds. This type of bond indicates the fixed coupon in the bond certificate. Bondholders cannot expect any change in the amount they receive, regardless of market fluctuations.
If interest rates go down, bondholders can get more for their investment. If rates go up, bondholders can get the short end of the stick.
- Floating rate bonds have coupon rates that move according to a benchmark. These benchmark rates are derived from variable interest rates for bank bills, which are short-term investments between banks.
To arrive at the floating rate for either a quarter or semi-annual period, the bank bill interest rate is usually added to a fixed margin rate. Since rates vary, bondholders should expect the amount they would receive to vary.
Floating rate corporate bond prospectuses must indicate the coupon payment schedule and how it will be calculated to meet the condition of full disclosure.
- Zero coupon bonds don’t pay any interest rate for the entire duration of the contract but pay everything off once the bond matures—like getting a lump sum payment. However, the bondholder must still pay taxes for the unreceived interest payments each year.
Inflation linked bond: This type of bond protects investors from both inflation and deflation because it pays investors a certain margin over the Consumer Price Index (CPI). Even if the actual value of the bond declines due to the bond market’s movement, bondholders can still count on some income.
The catch: Inflation linked bonds are usually issued by ‘high-credit risk’ companies, which means potential investors run a higher risk of actually losing their principal investment.
Corporate bond taxation
There are various ways corporate bonds get taxed in foreign markets, but it is straightforward in Australia.
Any and all earnings bondholders obtain from their corporate bonds are considered part of their income and taxed at their effective marginal tax rate (EMTR). That means whatever income tax rate is applied to a person’s salary also applies to their corporate bond.
The tax rate changes when the corporate bond investment is a part of a person’s superannuation investment. For bonds within a Super portfolio, the Superannuation Industry (Supervision) Act 1993 (SISA) rules on taxation would apply.
ASX corporate bond codes
The Australian Securities Exchange (ASX) usually lists coded descriptions of company-issued bonds. These may be found in various media, such as:
- ASX website
- Trading screens
- Financial newspaper reports
- Broker and financial advisor offices
Corporate bond codes may be short, abbreviated or long with a maximum of 9, 20 or 50 characters, respectively.
For example, a bond from the Australia and New Zealand Banking Group Ltd. (ANZPE) in long form code is shown in the ASX website as CAP NOTE 6-BBSW+3.25% PERP NON-CUM RED T-03-24.
When broken down, this means:
CAP NOTE: A note which indicates that the issuer or a third party regulator may prematurely end the bond if certain situations occur.
6-BBSW+3.25%: The company will release coupon payments semi-annually or every six months. The bond is a floating interest rate bond and the coupon is calculated using the six-month Bank-Bill Swap Rate (BBSW) plus a 3.25 per cent margin.
PERP: The bond has no set maturity date and will only be terminated if the issuer or a regulator decides to do so. This means the bondholder may choose to sell it at any time and the bond issuer is bound to pay coupon for as long as the bond exists.
Perpetual bonds are more like equities than debt.
NON-CUM: The bond is non-cumulative. This means that if the bond issuer was unable to pay coupon for a specific payout, they are not obligated to pay bondholders for that period.
RED: Since the bond is perpetual and has no maturity date, it is redeemable at any time.
T-03-24: It is possible to trigger a conversion or redemption for the bond by March 2024.
The abbreviated and short-form versions of the sample ANZPE code above are CN 6M PER RD T and NYR6QUT, respectively, and they mean the exact same thing as their long-form counterpart.
If you are unable to decipher the coded description of a bond offered in the bonds market, ask a professional broker or agent and check the bond certificate and indenture agreement of the bond you plan to invest in.
This information has been sourced from the Australian Securities Exchange and Nest Egg.