What is Corporate Bond? - ICICIdirect

What is Corporate Bond? A Corporate Bond is a financial instrument that allows a private or public corporation to borrow money from investors. In other words, when an investor buys a corporate bond, he/she lends money to the company (Issuer). In exchange, the company promises to repay the money (Principal) on a specified date in future (Maturity). Until that date, the company makes regular payment to investors at a specified rate of interest (Coupon). Thus, through a corporate bond, a company gets the money it needs for business operations and investors get a pre-defined interest payment for a specified period in lieu of the money lent to the Issuer. Illustration of a 5 year bond with 8% annual interest bought at par and held till maturity

Important Terminology

C oupon ? Interest paid to the investor periodically. Can range from monthly, quarterly, half-yearly to yearly.

Face Value ? Value per bond paid out by Issuer on maturity or on exercise of call option by Issuer

M aturity date ? The date on which Issuer repays principal amount. C redit Rating ? Quantified assessment of the creditworthiness of a borrower in general

terms or with respect to a particular bond by Credit Rating Agencies C all option on bonds ? Gives issuer of the bond the option to call back the bond before its

maturity and repay principal amount. Feature is common in perpetual bonds. The option is exercised by the issuer when interest rates decline and capital requirement can be met at lower cost. Y TM (Yield to Maturity) ? Annualized return on the bond realized by an investor if bond is held to maturity. Accrued Interest ? Amount of interest earned on a debt but not yet collected. Interest starts accumulating from the last coupon payment date. C lean Price ? Price of the bond without accrued interest on that bond. Dirty Price ? Clean price of the bond + accrued interest = Dirty Price of the bond. It is the actual consideration paid by buyer of the bond to the seller. Is also known as settlement price of the bond.

Ways to buy Corporate Bonds

P r imary Issue ? Directly from Issuer by subscribing to bonds during public issuance S econdary Market ? Post listing, through exchanges or financial intermediaries

C lassification of Corporate Bonds

A) By Maturity:

S hort Term ? 3 years or less Medium Term ? 4 years to 10 years Lo ng Term ? more than 10 years Perpetual ? No fixed maturity date. However, Issuer has an option to call the bond &

redeem principal at pre-defined intervals

B) By Interest Payment:

Fixed Rate Bonds ? Rate of interest remains the same from issuance till maturity. Also known as pain vanilla bonds

Floating Rate Bonds ? Rate of interest in subject to reset periodically. Is linked to a benchmark rate

Z ero coupon Bonds ? Withhold interest payments till maturity. Issued at a discount to face value and redeemed at par

C) By Risk:

In vestment Grade ? Rated BBB- and above by Credit Rating Agencies High Yield ? Rated BB+ and lower. These bonds are also known as `Junk Bonds'

S eniority Ranking of Bonds

Benefits

Attractive Yield ? Higher yield than comparable maturity government bond Regular Cash Flow ? Steady & predictable income to meet expenses W ide Choice ? Choose from variety of sectors, tenure and credit rating Less Risky than Equity & Property ? Priority of claim to bond holders in case of default. T r ansparency & low cost than Bond Funds ? Choose individual corporate bond as per

one's risk profile & no annual recurring expense Diversification ? Bonds often act as a counterbalance to equities, moving opposite to

stocks Marketable & Transferable ? No lock-in. Bonds can be sold or transferred before maturity.

Risks

C redit or Default Risk ? Issuers inability to pay interest and/or principal payment due to weakening of creditworthiness. Can be partially mitigated by investing in high rated bonds

Du ration Risk ? Sensitivity of bond prices to change in interest rates. Higher coupon & higher number of years to maturity results in more price volatility to change in interest rate

In terest Rate Risk ? Change in price of bond to change in interest rates. Bond prices move opposite to the direction of interest rates. When interest rates fall, bond prices go up and vice versa.

Liquidity Risk ? Lack of active trading on the bond may result in illiquidity. Bond holders are unable to find buyers for the bond and/or receive sub-optimal price on Sale.

 In flation Risk ? Inflation rising above coupon rate resulting in negative real return. For example, if coupon is 6% and inflation rises to 7%, investors fall behind inflation by 1%

C all & Reinvestment Risk ? Issuer redeeming principal prior to maturity and inability of buyer to find similar coupon through fresh investment. Witnessed in a falling interest rate scenario.

Un derstanding Yield

Bond yield is the return an investor realizes on a bond. It is the anticipated return on an investment, expressed as an annual percentage. For example, a 8% yield means that the investment averages 8% return each year till maturity. Yield is an important concept in bond investing. It is used to measure return of one bond against another and it enables investors to make informed decision while investing in bonds.

Yield is commonly measured in two ways, current yield and yield to maturity.

A) C urrent yield

The current yield is the annual return on the investment value of bond, regardless of its maturity. If you buy a bond at par, the current yield equals its coupon rate. Thus, the current yield on a parvalue bond paying 8% is 8%. However, if the market price of the bond is higher or lower than par, the current yield will be different. For example, if you buy a Rs. 1000 bond with a 8% stated interest rate at Rs. 1100, your current yield would be 7.27% (Rs. 1000 x 0.08/Rs.1100).

B) Y ield to maturity

It is the total return an investor receives on a bond if held until maturity. It enables one to compare bonds with different maturities and coupon rates. Yield to maturity includes the current yield and the capital gain or loss you can expect if you hold the bond to maturity. If you pay Rs. 900 for a 5% coupon bond with a face value of Rs. 1,000 maturing five years from the date of purchase, you will earn not only Rs. 50 a year in interest but also another Rs. 100 when the bond's issuer pays off the principal. By the same logic, if you buy that bond for Rs. 1,100, representing a Rs.100 premium, you will lose Rs. 100 at maturity.

E xample 1 - YTM illustration of a 5 year bond with 8% annual interest bought at Premium and h eld till maturity

Example 2 - YTM illustration of a 5 year bond with 8% annual interest bought at discount and held till maturity

In terest Rates, Price and Yield Take a 10-year bond with a coupon interest rate of 5%. It pays Rs. 5 a year for every Rs. 100 of face value. What happens if interest rates rise to 6% after the bond is issued? New bonds will have to pay a 6% coupon rate or no one will buy them. By the same logic, you could sell your 5% bond only if you offered it at a price that produced a 6% yield to maturity for the buyer. So the price at which you could sell would be the price for which Rs. 5 annual interest and capital gain upto maturity represents 6% annual return -- in this case, Rs. 92.6. Thus, you'd lose Rs. 7.4 if you sold. (If, however, you held the bond to maturity and the issuer didn't default, yo u'd get back the full Rs. 100 you paid for the bond.) But what if interest rates were to decline? Let's say rates drop to 4% while you're holding your 5% bond. New bonds would be paying only 4% and you could sell your old bond for the price for which Rs. 5 annual interest and capital loss upto maturity represents 4% yield to maturity ? in this case Rs. 108.1. Thus, you'd gain Rs. 8.1 if you sold.

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