Understanding the Corporate Bonds and Risks Related to them

Corporate bonds are promissory notes that large firms issue to raise long-term and short-term debt. These bonds are issued with either an attached coupon or with no interest rate but a discounted price. They are issued in denominations (face value) of $1000 and pay interest twice yearly (semi-annual). These bonds enable firms to raise capital at a lower cost and provide flexibility.

However, unlike government bonds such as T-bills issued by the USA or gilts issued by the UK government. Corporate bonds carry “default, payment, and interest rate risk” for their investors—the degree of risk and its nature changes based on who is issuing the bond. If APPLE Plc issues the bonds, its risks are much different from those of a firm based in India. Because both firms’ operations, income currency and credit ratings are foreign.

Risk Related to Corporate Bonds

The four three major types of risk related to corporate bonds are as follows.

1. Default risk means that a borrower may default before or even on the maturity of the bonds. Bonds are forward promissory notes, meaning the principal you invest today will be due in future. For example, a $1000 -10-year bond with a 10% coupon rate would result in two payments: a principal amount of $ 1000 at the end of year 10 and an annual fee of $100 (10% of 1000) at the end of every year. After making the 7 interest payments to you, the firm may go bankrupt or dissolve, so you may never receive your principal.
2. Payment risk refers to the risk that the bond issuer cannot pay their annual or semi-annual interest payment. For example, during Covid-19, many firms like airlines could not earn any income. As a result, they required a “payment holiday” during the covid year. Therefore, an investor investing in corporate bonds should be ready to handle payment risk.
3. Interest rate risk: the bond price is inversely related to the interest rate set by the central banks. Therefore, if the interest rate goes up (like nowadays), the value of the bond will start to go down. This means that if, as an investor, you wish to sell the $1000 bond now rather than waiting for 10 years of maturity, you may have to sell it for a price lower than $1000.
4. Exchange rate risk is caused by exchange rate volatility. If you invest in foreign currency bonds such Indian rupee or KSA rials, you may lose money to the value of £ appreciates due to a change in the exchange rate. Because now, for the same units of foreign currency, you may get a lower £. However, this can also become a source of extra income if the value of £ decreases.
5. Call risk: Bondholders also need to manage the call risk, whereby the bond terms give the company the right to buy back the bond before the maturity date. This risk represents a lost income risk for the bond investors.
6. Liquidity risk: liquidity risk refers to the lack of demand for a particular bond. Bondholders may need help selling their bonds or may have to sell them at a heavily discounted price.
7. Interest rate risk refers to the risk of a fall in bond prices whereby a rise in interest rate leads to lower bond prices. For example, as interest rates have recently increased, bond values have begun to fall rapidly.
8. Inflation risk refers to the fall in the value of a bond’s principal or interest payments. The fall happens as the real value of future cash flows declines due to higher inflation. In other words, inflation over time means the money received on the bond’s interest and principal payments will purchase fewer goods and services than before.

Corporate Bond types based on their Credit Ratings

Rating agencies like Moody’s, Fitch, and S&P rate firms and their issued bonds. These agencies may give credit ratings after solicitation with the bond issuer or without any solicitation. The associated credit ratings often indicate corporate bonds’ riskiness. Bonds deemed lower risk bonds usually have higher credit ratings, such as AAA or AA+. The higher-risk bonds are generally junk bonds, and their ratings are below BBB-. The interest rate charged to higher-rated bonds differs from lower-rated bonds. However, other than credit ratings feature of bonds such issuers’ leverage ratio, coverage ratios, and assets, etc. Based on the credit ratings, we can broadly categorise bonds into the following two types:

Investment Grade Bonds: Bonds rated Baa or better by Moody’s and BBB or better by S&P are considered investment grade bonds. 

Junk Bonds: These are bonds with credit ratings lower than BBB– also called speculative grade bonds. These bonds are also called junk or high-yield bonds. A junk bond is a risk investment that is likely to default. In comparison, the default risk of investment-grade bonds is negligible. 

Understanding Corporate Bonds and their Characteristics

Corporate bond issuers often use the bonds’ characteristics to indicate the bond’s credit quality to the investors. The following are the major characteristics of corporate bonds firms use to show their credit quality.

1. Restrictive/Protective Covenants: an issuer may use certain conditions to ensure bond investors will not suffer from “agency of conflict”. These covenants provide that managers do not make money for themselves or the shareholders at the expense of bond investors. These covenants limit the management by putting constraints on the following:

• How much dividends can management pay to ensure enough cash reserves for interest payments?
• How much additional debt (bonds) can the firm issue to ensure they stay manageable with debt?
• The seniority of the later debt issuance, which ensures that bonds issued later would be after the existing bondholders are paid in full.

 Restrictive covenants mean that bondholders are well protected, and as a result, these bonds usually offer lower interest rates.

2. Call Provision: Call provision refers to an issuer has right to force the bond holder back earlier than its maturity. There is a grace period before which an issuer may call; however, after this call, they can call the bond at either face value or higher than market price as part of bond terms and conditions. The issuer can also call part of their total bond stock (such as only 10% of issued bonds are called). Doing so gives the investor confidence that the firm is generating sufficient cash. Furthermore, the probability of default decreases. The firm becomes safer as its overall debt decreases.

A call provision is also put in place that if a firm decides to engage in an activity not viewed favourably by investors, then the firm can pay back those bondholders and continue with their business. For example, if a bond covenant restricts firms from investing in an emerging economy. The management views investing in an emerging economy as compelling; they can continue after paying the bondholders in full.

Firms also use call provision to manage their capital structure. The debt-to-equity ratio is very low if they feel that existing bond levels make their firm too indebted. Then, they may force bondholders to sell their bonds to reduce the level of debt and improve their financial risk profile and creditworthiness.

However, the call provisions ensure that management fully controls its debt and debt management. Nevertheless, these provisions are viewed negatively; bondholders want higher interest rates for bonds with call provisions.

3. Conversion: Some bonds allow bondholder to convert their bonds into stocks/shares if they prefer. This characteristic allows the bondholders to benefit if the firm’s share prices have increased. The convertibility provision states the number of shares the bondholders can claim for one bond. The convertible bonds signal to the market about a firm’s prospects.

If management believes the firm’s share prices will increase, they may issue a convertible bond. Therefore, bond investors like such bonds as it gives them the best of both worlds.

4. Secured Bonds: These bonds have collateral attached to them. The collateral can be property, equipment, land, or other fixed assets. These bonds usually finance a predefined project or specific business capital expenditures. The bondholder can liquidate the property or asset if firms do not make interest or principal payments. These bonds are assumed to be safer and have lower interest rates. Similarly, firms may issue equipment trust certificates against non-real estate assets such as heavy equipment and aeroplanes

5. Unsecured bonds: Firms can issue unsecured bonds having attached a customised set of terms and conditions. These terms and conditions, indenture, show both parties’ rights and responsibilities to a bond issue (firms and bondholders). They are risky assets with a higher interest rate; however, payment priority is the last in case of default.

6. Credit Ratings: firms can also use the rating agencies to indicate their firm’s credit quality and the credit quality of their issued bonds. The ratings, such as the AAA to D scale, show the firm’s creditworthiness.

7. Financial guarantees: Sometimes, bond issuers purchase financial securities such as insurance against the event of default. This guarantee ensures that borrowers can get their principal and interest payments. This guarantee is issued by large banks such as JP Morgan or Bank of America. Therefore, borrowers can handle the quality of the bond issuer. Instead, they would look at the insurer’s quality and consider the issued bonds good quality. These insurance instruments are called “Credit Default Swaps (CDS)”. These instruments are traded and allow investors to secure their bonds.

Types of Corporate Bonds based on their Characteristics

The following are the main types of bonds firms use to raise capital.

1. Secured Bonds.
2. Unsecured Bonds – Debentures.
3. Unsecured Bonds – Convertibles
4. Unsecured Bonds – Debentures.
5. Unsecured Bonds – Subordinate Debentures.
6. Unsecured Bonds – Variable rate bonds.
7. Unsecured Bonds – Puttable Bonds. 
8. Investment grade and Junk (speculative) grade Bond
9. Mortgage-Backed Securities

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We will discuss these types in detail in another article.