What are Corporate Bonds ?
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When companies want to expand or fund new business initiatives, they can seek to access the corporate bond market to borrow money. A company decides how much it would like to borrow and then issues a bond offering for the amount required; investors that buy the bond are effectively lending money to the company.
The terms are provided in the bond offering or prospectus.
Unlike equities, ownership of corporate bonds does not provide an ownership interest in the company that has issued the bond.
The company pays the investor a rate of interest over a given set period of time and repays the principal at the maturity date established at the time of the bond’s issue.
Many corporate bonds have redemption or call features that can affect the maturity date, most are loosely categorized into the following types:
Short-term notes (with maturities of up to five years)
Medium-term notes (with maturities ranging between five and 12 years)
Long-term bonds (with maturities greater than 12 years)
Corporate bonds are rated according to credit quality. Rating agencies such as Moody’s Investors Service and Standard & Poor’s provide independent analysis of corporate bond issuers, grading each issuer according to its creditworthiness.
Corporate bond with lower credit ratings tend to pay higher interest rates on their corporate bonds however carry greater risk.
Corporate bonds fall into 2 classification types: investment-grade and speculative-grade (or high yield) bonds. Speculative-grade bonds, are issued by companies perceived to have a lower level of credit quality compared to more highly rated, investment-grade, companies. The investment-grade category has four rating grades while the speculative-grade category is comprised of six rating grades.
The price of a corporate bond depends on several factors, including the maturity, the credit rating of the company issuing the bond and the general level of interest rates.
Most corporates have usually more credit risk and higher yields than government issued bonds.
This creates a credit spread between corporates and government bonds, so that the corporate bond investor earns extra yield by taking on greater risk.
Corporate bonds can offer a range of potential benefits including:
Diversification: Corporates offer the opportunity to invest in a variety of economic sectors. Within the broad spectrum of corporates there is a wide divergence of risk and yield. Corporate bonds can add diversification to an equity portfolio as well as diversify a fixed income portfolio of government bonds or other fixed income securities.
Income: Corporates have the potential to provide attractive income. Most corporate bonds pay on a fixed semi-annual amount.
Higher yields: Corporates tend to provide higher yields than comparable maturity government bonds.
Liquidity: Corporate bonds can be sold at any time prior to maturity in a large and active secondary trading market.
What are the risks?
Both government bonds and corporate bonds are exposed to interest rate risk. In addition, corporate bonds also have credit or default risk - the risk that the borrower fails to repay the loan and defaults on its obligation.
The level of default risk varies based on the underlying credit quality of the issuer.
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