Investing in the Bond Market, Part 4: Corporate Bonds, The Basics

This is part four of a series on the bond market, specifically the basics of corporate bonds. Click here for part one. Click here for part two. Click here for part three.

Corporate bonds represent one of the largest segments of the U.S. credit market, and there are several different ways to invest. Some companies offer senior debt, while others choose subordinated debt. Corporations which are in or close to bankruptcy issue distressed debt. It all depends on the needs of the company and what sort of terms it can make attractive for bond investors.

Bond classification

Corporate bonds differ from stock or equity in one very important way. When investors buy stock in a company, they are buying shares or small pieces of that company, meaning they have a very small ownership interest in it. On the other hand, when investors buy bonds, they are actually loaning the company money, so they don’t have an ownership interest and instead are serving as a creditor.

Corporations can use the proceeds from a bond offering to pay for new equipment, buy back stock, invest in research and development, pay dividends to shareholders, finance mergers and acquisitions, or refinance debt. Companies issue bonds in blocks of $1,000 in par value.

There are a few different ways to classify bonds. One is by their maturity date or the length of their term. Maturities can be as little as three years or as long as 10 years. In general, the longer the term, the higher the interest rate will be because the risks of holding them are greater. Corporate debt with a maturity of less than one year is referred to as commercial paper.

Corporate bonds can also be classified by the type of interest they pay, or the coupon rate. For example, some have a fixed rate and pay the same percentage throughout the term of the bond, while others have floating rates which reset on a regular basis, often every six months. Floating rates are generally based on a benchmark, like whatever the interest rate is on the comparable Treasury bond, plus 1 percentage point.

Zero-coupon bonds don’t pay any interest throughout their terms, but they do make one higher lump payment at the end. For example, a five-year, zero-coupon bond may cost $1,000 to purchase but have a face value of $1,200. However, zero-coupon bonds are less common than interest-paying bonds.

Investment-grade versus high-yield bonds

An even more important way to classify bonds is by the credit rating of the company that’s offering them. The corporation’s credit rating impact whether bonds are classified as investment-grade or high-yield, which can be another term for junk bonds when it comes to companies with troubled balance sheets. Investment-grade bonds receive that classification because they are more likely to be paid back on time than high-yield bonds. However, high-yield bonds tend to pay more over time because they carry higher interest rates due to the significantly increased risks associated with holding them.

Investment-grade bonds are those issued with credit ratings of AAA, AA, A and BBB. The credit ratings mean these bonds are at a fairly low risk of default compared to so-called junk bonds, which are rated at BB, B, CCC or lower. Credit rating agencies like Moody’s, Fitch, and Standard & Poor’s hand out the ratings, with each agency having its own system for rating bonds.

Investment-grade bonds with the lowest rating in the BBB category are sometimes referred to as “speculative-grade” because they are more vulnerable to economic conditions than the other two investment-grade categories. Despite their vulnerability, the companies which have issued the bonds that fall into this category are generally stable and can show ability to pay back their debt.

Sometimes investment-grade bonds can be downgraded from BBB to BB, which moves their classification down to junk status even though it’s only a single notch on the rating ladder. This downgrade signals that the company may have problems repaying its debt. When this happens, the bonds are sometimes called “fallen angels.”

Junk bonds are more officially referred to as high-yield bonds because the emphasis is on the higher yield they pay. Companies which don’t have very strong credit ratings will have to pay more in interest, resulting in higher yields for their bonds. Investors want to be compensated for taking on the additional risk associated with high-yield or junk bonds.

Senior debt, subordinated debt and distressed debt

Corporate bonds can also be classified as senior debt or subordinated debt. Senior debt takes priority over other forms of debt in the issuer’s capital structure, which means that bonds with this status will have their interest payments paid before those with subordinated status. This becomes especially important when it comes to corporations which are struggling to pay back their debt. Of course, there is less risk involved in investing in senior debt because if the company goes bankrupt, those bonds will be paid back before any bonds which are categorized as subordinated debt.

Bonds which are classified as distressed debt are issued by companies that have either filed for bankruptcy or will probably file. Although governments in financial peril can offer distressed debt in certain cases, this type of credit is more common among corporations, for obvious reasons.

Corporations can be in a distressed state for a number of different reasons, but investors who like to focus on these types of bonds will look for those that are distressed for what would be considered the right reasons.

For example, skilled distressed debt investors learn how to spot a company that is likely to regain its footing. They buy these distressed securities at a deep discount because they believe the bonds will be paid back even though the company has gotten into a difficult spot. Sometimes companies become distressed because they have taken on too much debt, and this presents an opportunity for wise investors. Investors who buy bonds at a distressed price will gain power over what happens to the company because they have taken on some of its debt.

Of course, distressed debt of any kind presents much more risk than senior debt or even subordinated debt, but if the gamble pays off, it can become quite profitable.

The next article in this series will focus on some more advanced concepts regarding corporate bonds, like categorizing them according to the type of payout and other features or options they offer.

About the Author

Trading and investing in markets is second nature to some, but a mystery to others. The goal is to provide a forum where everyday people aspiring to be part time or full time traders will learn how view markets differently and profit beyond their wildest dreams.

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