WHAT ARE CORPORATE BONDS?
Corporate bonds are debt obligations, or IOUs, issued by private and public corporations. They are typically issued in multiples of $1,000 and/or $5,000. Companies use the funds they raise from selling bonds for a variety of purposes, from building facilities to purchasing equipment to expanding the business.
When you buy a bond, you are lending money to the corporation that issued it, which promises to return your money, or principal, on a specified maturity date. Until that time, it also pays you a stated rate of interest, usually semiannually. The interest payments you receive from corporate bonds are taxable. Unlike stocks, bonds do not give you an ownership interest in the issuing corporation.
THE CORPORATE BOND MARKET
The corporate bond market is large and liquid, with daily trading volume estimated at $10 billion. Issuance for the first half of 1997 was an estimated $312.2 billion. The total market value of outstanding corporate bonds in the United States at the end of the first half of 1997 was approximately $2.1 trillion.
Two markets actually exist for buying and selling corporate bonds. One is the New York Stock Exchange (NYSE), where major corporations’ debt issues are quoted and traded every day. Surprisingly, more corporate bonds than stocks are listed on the NYSE. Includes all non-convertible debt and medium-term-note issues, but excludes all federal and agency debt.
The other is the over-the-counter (OTC) market, which has no central location. It is made up of bond dealers and brokers around the country who trade corporates and many other types of debt securities. The OTC market is much bigger than the exchange market; most bond transactions, even those involving listed issues, take place in this market.
Investors in corporate bonds include large financial institutions, such as pension funds, endowments, mutual funds, insurance companies and banks. Individuals, from the very wealthy to people of modest means, also invest in corporates because of the many attractions these securities offer.
ADVANTAGES OF CORPORATE BONDS
Investors buy corporates for a variety of reasons. First of all, corporates usually offer higher yields than comparable-maturity government bonds or CDs. This high-yield potential is generally accompanied by higher risks. People who want steady income from their investments, while preserving their principal, include corporates in their portfolios. Corporate bonds are evaluated and assigned a rating based on credit history and ability to repay obligations. The higher the rating, the safer the investment.
Corporate bonds provide the opportunity to choose from a variety of sectors, structures and credit-quality characteristics to meet your investment objectives. If you must sell a bond before maturity, in most instances you can do so easily and quickly because of the size and liquidity of the market.
ISSUERS OF COPORATE BONDS
There are five main classifications of issuers representing various sectors that issue corporate bonds. These are public utilities, transportation companies, industrial corporations, financial service companies; and conglomerates.
Such issuers may be U.S. companies or foreign companies. Foreign governments are also frequent issuers in the U.S. markets.
TERMS OF BONDS
One of the key investment features of any bond is its maturity. A bond’s maturity tells you when you should expect to get your principal back and how long you can expect to receive interest payments. (However, some corporates have “call,” or redemption, features that can affect the date when your principal is returned. Maturities can be of several kinds. These can be maturities of 1-4 years, medium-term notes/bonds maturities of 5-12 years and maturities greater than 12 years.
Another important fact to know about a bond before you buy is its structure. With traditional debt securities, the investor lends the issuer a specified amount of money for a specified time. In exchange, the investor receives fixed payments of interest on a regular schedule for the life of the bonds, with the full principal returned at maturity. In recent years, however, the standard, fixed interest rate has been joined by other varieties. The three types of rates you are most likely to be offered are these:
Floating-rate. These are bonds that have variable interest rates that are adjusted periodically according to an index tied to short-term Treasury bills or money markets. While such bonds offer protection against increases in interest rates, their yields are typically lower than those of fixed-rate securities with the same maturity.
Zero-coupon. These are bonds that have no periodic interest payments. Instead, they are sold at a deep discount to face value and redeemed for the full face value at maturity. One point to keep in mind is that even though you receive no cash interest payments, you must pay income tax on the interest accrued each year on most zero-coupon bonds. For this reason, zeros may be most suitable for IRAs and other tax-sheltered retirement accounts.
INTEREST RATE RISK
Like all bonds, corporates tend to rise in value when interest rates fall, and they fall in value when interest rates rise. Usually, the longer the maturity, the greater the degree of price volatility. By holding a bond until maturity, you may be less concerned about these price fluctuations (which are known as interest-rate risk, or market risk), because you will receive the par, or face, value of your bond at maturity.
Some investors are confused by the inverse relationship between bonds and interest rates – that is, the fact that bonds are worth less when interest rates rise. But the explanation is essentially straightforward:
When interest rates rise, new issues come to market with higher yields than older securities, making those older ones worth less. Hence, their prices go down. When interest rates decline, new bond issues come to market with lower yields than older securities, making those older, higher-yielding ones worth more. Hence, their prices go up.
As a result, if you have to sell your bond before maturity, it may be worth more or less than you paid for it.
Various economic forces affect the level and direction of interest rates in the economy. Interest rates typically climb when the economy is growing, and fall during economic downturns. Similarly, rising inflation leads to rising interest rates (although at some point, higher rates themselves become contributors to higher inflation), and moderating inflation leads to lower interest rates. Inflation is one of the most influential forces on interest rates.
YIELDS
Yield is a critical concept in bond investing, because it is the tool you use to measure the return of one bond against another. It enables you to make informed decisions about which bond to buy.
In essence, yield is the rate of return on your bond investment. However, it is not fixed, like a bond’s stated interest rate. It changes to reflect the price movements in a bond caused by fluctuating interest rates.
Here is an example of how yield works: You buy a bond, hold it for a year while interest rates are rising and then sell it. You receive a lower price for the bond than you paid for it because, as indicated above under “Understanding Interest-Rate Risk,” no one would otherwise accept your bond’s now lower-than-market interest rate. Although the buyer will receive the same dollar amount of interest you did and will have the same amount of principal returned at maturity, the buyer’s yield, or rate of return, will be higher than yours was–because the buyer paid less for the bond.
There are numerous types of yield, but two–current yield and yield to maturity – are of greatest importance to most investors.
The current yield is the annual return on the dollar amount paid for a bond, regardless of its maturity. If you buy a bond at par, the current yield equals its stated interest rate. Thus, the current yield on a par-value bond paying 6% is 6%.
However, if the market price of the bond is more or less than par, the current yield will be different. For example, if you buy a $1,000 bond with a 6% stated interest rate after prevailing interest rates have risen above that level, you would pay less than par. Assume your price is $900. The current yield would be 6.67% ($1,000 x .06/$900).
A more meaningful figure is the yield to maturity, because it tells you the total return you will receive if you hold a bond until maturity. It also enables you to compare bonds with different maturities and coupons. Yield to maturity includes all your interest plus any capital gain you will realize (if you purchase the bond below par) or minus any capital loss you will suffer (if you purchase the bond above par).
Ask your broker to provide you with the precise yield to maturity of any bond you are considering. Don’t buy on the basis of the current yield alone, because it may not represent the bond’s real value to you.
“CALL” AND REFUNDING RISK
One of the most difficult risks for investors to understand is that posed by “call” and refunding provisions. If the bond’s indenture (the legal document that spells out its terms and conditions) contains a “call” provision, the issuer retains the right to retire (that is, redeem) the debt, fully or partially, before the scheduled maturity date. For the issuer, the chief benefit of such a feature is that it permits the issuer to replace outstanding debt with a lower-interest-cost new issue.
A call feature creates uncertainty as to whether the bond will remain outstanding until its maturity date. Investors risk losing a bond paying a higher rate of interest when rates have declined and issuers decide to call in their bonds. When a bond is called, the investor must usually reinvest in securities with lower yields. Calls also tend to limit the appreciation in a bond’s price that could be expected when interest rates start to slip.
Because a call feature puts the investor at a disadvantage, callable bonds carry higher yields than noncallable bonds, but higher yield alone is often not enough to induce investors to buy them. As further inducement, the issuer often sets the call price (the price investors must be paid if their bonds are called) higher than the principal (face) value of the issue. The difference between the call price and principal is the call premium.
Generally, bondholders do have some protection against calls. An example would be a bond that has a 15-year final maturity, noncall two years. This means the investor is protected from a call for two years, after which time the issuer has the right to call the bonds.
A sinking fund is money taken from a corporation’s earnings that is used to redeem bonds periodically, before maturity, as specified in the indenture. If a bond issue has a sinking-fund provision, a certain portion of the issue must be retired each year. The bonds retired are usually selected by lottery.
One investor benefit of a sinking fund is that it lowers the risk of default by reducing the amount of the corporation’s outstanding debt over time. Another is that the fund provides price support to the issue, particularly in a period of rising interest rates. However, the disadvantage – which usually weighs more heavily on investors’ minds, especially in a falling-rate environment – is that bondholders may receive a sinking-fund call at a price (often par) that may be lower than the current market price of the bonds.
Bond investors should be aware of the possibility of certain other kinds of calls. Some bonds, especially utility securities, may be called under what are known as Maintenance and Replacement fund provisions (which relate to upgrading plant and equipment). Others may be called under Release and Substitution clauses (which are designed to maintain the integrity of assets pledged as collateral for some bonds) and Eminent Domain clauses (which have to do with paying off bonds when a governmental body confiscates or otherwise takes assets of the issuer). Ask about these and any other special redemption provisions that may apply to bonds you are considering.
You can avoid the complications and uncertainties of calls altogether by buying only noncallable bonds without sinking-fund provisions. If you do buy a callable bond and it is called, be aware that its actual yield will be different than the yield to maturity you were quoted. So ask your broker to tell you what the yield to call is as well.
Just as some issuers have the right to call your bond prior to maturity, there is a type of bond – known as a put bond – that is redeemable at your option prior to maturity. At specified intervals, you may “put” the bond back to the issuer for full face value plus accrued interest. In exchange for this privilege, you will have to accept a somewhat lower yield than a comparable bond without a put feature would pay.
COLLATERALIZATION
In the event a corporation goes out of business or defaults on its debt, bondholders, as creditors, have priority over stockholders in bankruptcy court. However, the order of priority among all the vying groups of creditors depends on the specific terms of each bond, among other factors.
One of the most important factors is whether the bond is secured or unsecured. If a bond is secured, the issuer has pledged specific assets (known as collateral) that can be sold, if necessary, to pay the bondholders. If you buy a secured bond, you will “pay” for the extra safety by receiving a lower interest rate than you would have got on a comparable unsecured bond.
Most corporate bonds are debentures – that is, unsecured debt obligations backed only by the issuer’s general credit and the capacity of its earnings to repay interest and principal. However, even unsecured bonds usually have the protection of what is known as a negative pledge provision. This requires the issuer to provide security for the unsecured bonds in the event that it subsequently pledges its assets to secure other debt obligations.
Credit ratings are a key tool for the average investor who wants to know how strong a company’s unsecured bonds are. These are bonds for which real estate or other physical property worth more than the bonds has been pledged as collateral. They are mostly issued by public utilities.
There are various kinds of mortgage bonds, including the following: first, prior, overlying, junior, second, third and so on. The designation reflects the priority of the lien, or legal claim, you have against the specified property. Any time you invest in mortgage bonds, you should find out how much other debt of the issuer is secured by the same collateral and whether the lien supporting that other debt is equal or prior to your bond’s lien. A corporation may deposit stocks, bonds and other securities with a trustee to back its bonds. The collateral must have a market value at least equal to the value of the bonds.
Debt that is subordinated, or junior, has a priority lower than that of other debt in terms of payment (but like all bonds, it ranks ahead of stock). Only after secured bonds and debentures are paid off can holders of subordinated debentures be paid. In exchange for this lower status in the event of bankruptcy, investors in subordinated securities earn a higher rate of interest than is paid on senior securities.
Another form of security is a guarantee of one corporation’s bonds by another corporation. For example, bonds issued by a subsidiary may be guaranteed by the parent corporation. Or bonds issued by a joint venture between two companies may be guaranteed by both parent corporations. Guaranteed bonds become, in effect, debentures of the guaranteeing corporation and benefit from its presumably better credit.
CREDIT RISK
A bond issuer’s ability to pay its debts – that is, make all interest and principal payments in full and on schedule – is a critical concern for investors. Most corporate bonds are evaluated for credit quality by Standard & Poor’s, Moody’s Investors Service, Fitch Investors Service, Inc. and Duff & Phelps Credit Rating Co. (See their rating systems in the chart below) Checking a bond’s rating before buying is not only smart but also simple: Just ask your broker.
Bonds rated BBB or higher by Standard & Poor’s, Fitch and Duff & Phelps, and Baa or higher by Moody’s, are widely considered “investment grade.” This means the quality of the securities is high enough for a prudent investor to purchase them
CREDIT RATINGS
Some bonds are not rated, but this does not necessarily mean they are unsafe.
Bonds with a rating of BB (Standard & Poor’s, Fitch and Duff & Phelps) or Ba (Moody’s) or below are speculative investments. They are called high-yield, or junk, bonds. Such bonds are issued by newer or start-up companies, companies that have had financial problems, companies in a particularly competitive or volatile market and those featuring aggressive financial and business policies. They pay higher interest rates than investment-grade bonds to compensate for the extra risk. However, if they were issued before the company’s financial difficulties, the risk may not be offset by a higher yield. (Please see Appendix).
For those who do not mind taking substantial risk, such securities can provide exceptional returns. For the less adventurous who still want to participate in this market, high-yield bond mutual funds are a way to spread the risk over many issues.
In recent years, the managements of many corporations have tried to boost shareholder value by undertaking leveraged buyouts, restructurings, mergers and recapitalizations. Such events can push bond values down, sometimes very suddenly, because they may greatly increase a company’s debt load. Although some corporations have now established bondholder protections, these are neither widespread nor foolproof. An individual investor should see if the rating agencies have written commentaries on a company’s vulnerability to event risk before buying its bonds.
BOND FUNDS
Many investors who want to reap the good returns available in the corporate bond market buy shares in bond mutual funds instead of individual bonds – or in addition to individual bonds. They do so for the same reasons investors have flocked to mutual funds of all kinds in recent years – diversification, professional management, modest minimum investments, automatic dividend reinvestment and other convenience features.
Diversification is an especially important advantage of bond funds. Many investors in individual bonds buy only a few securities, thus concentrating their risk. A fund manager, by contrast, spreads credit risk, interest-rate risk and, indeed, all other kinds of risk, over many bonds. Different issuers, sectors, credit ratings, coupons and maturities are all represented in a diversified portfolio.
However, lower risk does not mean no risk. All the underlying risks that affect bonds affect bond funds – but not as sharply. You should be aware that prices of bond fund shares fluctuate inversely with interest rates, just as individual bonds’ prices do, and when you sell fund shares, they may be worth more or less than you paid for them.
HOW CORPORATE BONDS ARE TAXED
The interest you receive from corporate bonds is subject to federal and state income tax. You may generate capital gains on a corporate bond if you sell it at a profit before it matures. If you sell it within less than a year from purchase, the gains are taxed at your ordinary rate. If you sell it after a year, your capital gains are considered long-term and are currently taxed at a maximum rate of 28%.
Conversely, if you sell a bond for less than you paid, you may incur a capital loss. You may offset an unlimited amount of such losses dollar for dollar against capital gains you have realized on other investments (bonds, stocks, mutual funds, real estate, etc.). If your losses exceed your gains, you may currently deduct up to $3,000 of net capital losses annually from your ordinary income. Any capital losses in excess of $3,000 are carried forward and can be used in future years. (These rules apply to the sale of shares in bond funds as well as to individual bonds.)
When bonds are issued at substantially less than par (face) value, the difference between the face amount and the initial offering price is known as original-issue discount. Zero-coupon bonds are the best-known variety of this category of bonds. The tax treatment of original-issue-discount bonds is particularly complicated, so if you plan to invest in them, it is essential to consult your tax attorney or adviser. During the time you own original-issue-discount bonds, you will pay tax each year on a portion of the discount (even though you do not receive it). However, if you hold them to maturity, you do not pay capital gains or other taxes on the amount by which the face value you receive exceeds the discounted amount you paid for the bonds. The reason is that you paid taxes on that excess incrementally each year that you held the bonds.
References
Byron, Michael. (1993). International Financial Markets. New York: Blackwell &
Co.
Williamson, Albert. (1994). Managing Financial Institutions. New York: McGraw
Hill, Inc.
Peterson, Anthony. (1996). Financial Institutions and Global Markets. Boston:
Anthony Peterson.