This is part five of a series on the bond market, specifically about corporate bond investing and how each type will pay interest. Click here for part one. Click here for part two. Click here for part three. Click here for part four.
One thing that makes corporate bonds more versatile than government or municipal bonds is the fact that they can come with a wider variety of options and terms. The payouts can be different too. For example, some corporate bonds are convertible, which means they can convert to equity at maturity. Investors should keep all such factors in focus when deciding which corporate bonds to invest in.
Floating-rate notes versus fixed-rate notes
Bonds can have either floating rates or fixed rates, depending on the issue. Fixed-rate notes pay the same interest rate over the life of the bond until its maturity date.
However, floating-rate notes have a variable coupon rate that changes according to a benchmark or other reference. Some common reference points include the London inter-bank offered rate (LIBOR) and the U.S. federal funds rate. The spread between the coupon rate and the reference point or benchmark remains the same and is usually expressed as the benchmark plus a percentage or basis points. For example, if the federal funds rate is set at 1%, and the spread is set at 0.5%, the rate would be 1.5%. If the percentage is expressed as basis points, then 0.5% would equal 50 basis points.
While most bonds pay interest every six months, most floating-rate notes pay it every three months. Floating-rate notes generally have lower yields than fixed-rate notes, but some investors prefer to sacrifice some yield in exchange for the security of a floating rate. As interest rates rise, so the interest payments on the bonds increase. On the other hand, if interest rates fall, interest payments on floating-rate notes decline. Thus, floating-rate notes are better for investors and worse for issuers during a time when interest rates are increasing.
Commercial paper
You may hear corporate bonds referred to by many different names, and each of these terms has to do with the way they are paid out or any options that have been embedded in them. For example, commercial paper is an unsecured bond with a fixed maturity no longer than 270 days.
Companies which issue commercial paper do so to pay short-term obligations like payroll. Only corporations with strong credit ratings will be able to sell commercial paper because investors must be able to trust that they will be paid back. Usually commercial paper is part of an ongoing program rather than a single issue.
Convertible bonds
Convertible notes can be converted into a set number of common shares in the company that issued them. The term “convertible note” is generally interchangeable with “convertible bond” and falls under the umbrella of convertible debt. Convertible notes have a maturity of no more than 10 years. If the maturity date is longer than that, it’s called a convertible debenture.
Convertible bonds also have conversion ratios or conversion premiums, which dictate how many common shares each of them is worth. For example, if a bond has a 50:1 conversion ratio, it means that each bond with a par value of $1,000 will be worth 50 shares of common stock when it’s converted. Some issuers include a premium in the conversion instead, which means if investors opt to convert the bonds into stock, they must pay what the shares are worth, plus the percentage given as the premium when the bonds are converted.
Most convertible notes are issued by companies that don’t have a great credit rating but do have potential for strong growth. While they do pay interest, the coupon rate is usually lower than rates offered on non-convertible bonds. Investors who buy convertible bonds receive additional value in the conversion to equity.
There are some important considerations for both the issuer and investor to make when weighing convertible notes or debentures. Issuers do benefit by being able to raise funds while paying less interest. They also benefit by having their debt paid off if the bonds are converted to equity. However, investors must remember that when they buy convertible bonds, not only are the interest payments smaller than they would be with a non-convertible bond, but they also face dilution of their investment when new shares are issued upon conversion of the bonds.
While conversion of the bonds into stock can be an option, issuers can also call the bonds, forcing them to be converted into common shares. This usually happens when the company’s stock price is more than it would be in the event that the bond is redeemed. It could also be converted on the call date.
Perpetual and extendible bonds
Perpetual bonds have no maturity date, which means they pay interest forever without redeeming the principal. In some ways, perpetual bonds are similar to stock, except bondholders do not have any voting powers or control over the issuer. Despite the similarity to equity, perpetual bonds still fall under fixed income, which means issuers are still required to pay the set coupon rates.
Extendible bonds carry an embedded option to have their maturity date extended. They are less common than other types of bonds, but investors might seek them out during times when interest rates are falling. Extendible bonds cost more than straight bonds (those without embedded options) because investors receive more value from the embedded option to extend them. Consequently, they have lower yields than straight bonds.
Puttable bonds
Bonds can also come with other options embedded, including put options. Investors who hold puttable bonds have the option to require the issuer to pay the principal back early. The option can be exercised on dates which are set when the bond is issued.
Puttable bonds can be attractive to investors because if interest rates increase after they purchase a bond, they can require the issuer to pay it back earlier than the maturity date. They can then use the funds from the redeemed bond to invest in other bonds with higher coupon rates. Because of the added value investors enjoy when buying puttable bonds, their yields are lower than those of similar straight bonds.
One risk involved in puttable bonds is that the issuer might not be able to pay back the funds on the date when an investor wants to exercise the put option. However, this is generally an extreme case seen in companies with major liquidity problems.
Callable bonds
The opposite of a puttable bond is a callable bond, which can be redeemed by the issuer before its maturity date. Although the two options are opposites, it is possible for a bond to embed both of them. The issuer of a callable bond may choose to pay off the bond at a set call price, but they are not required to do so. The call price is usually more than the par or issue price. On some bonds there is a sizable call premium, especially on high-yield bonds.
In general, callable bonds cost less than straight bonds because the issuer sees additional value by adding the call option. On the other hand, the yield on callable bonds is higher than the yield on straight bonds. For this reason, some investors will take a gamble on callable bonds.
Callable bonds carry a risk other types of bonds do not carry, which is reinvestment risk. The point of buying a bond in the first place is to lock in a steady income stream at a solid interest rate, but if the bond is called, then that steady income stream goes away. If interest rates fall between the time the bond was issued and the set call date, the issuer will usually call it and then refinance the debt at a lower interest rate.