Companies may issue bonds to finance operations. Most companies can borrow from banks, but view direct borrowing from a bank as more restrictive and expensive than selling debt on the open market through a bond issue.
The costs involved in borrowing money directly from a bank are prohibitive to a number of companies. In the world of corporate finance, many chief financial officers (CFOs) view banks as lenders of last resort because of the restrictive debt covenants that banks place on direct corporate loans. Covenants are rules placed on debt that are designed to stabilize corporate performance and reduce the risk to which a bank is exposed when it gives a large loan to a company. In other words, restrictive covenants protect the bank's interests; they're written by securities lawyers and are based on what analysts have determined to be risks to that company's performance.
Here are a few examples of the restrictive covenants faced by companies: they can't issue any more debt until the bank loan is completely paid off; they can't participate in any share offerings until the bank loan is paid off; they can't acquire any companies until the bank loan is paid off, and so on. Relatively speaking, these are straightforward, unrestrictive covenants that may be placed on corporate borrowing. However, debt covenants are often much more convoluted and carefully tailored to fit the borrower's business risks. Some of the more restrictive covenants may state that the interest rate on the debt increases substantially should the chief executive officer (CEO) quit or if earnings per share drop in a given time period. Covenants are a way for banks to mitigate the risk of holding debt, but for borrowing companies they are seen as an increased risk.
Simply put, banks place greater restrictions on what a company can do with a loan and are more concerned about debt repayment than bondholders. Bond markets tend to be more forgiving than banks and are often seen as being easier to deal with. As a result, companies are more likely to finance operations by issuing bonds than by borrowing from a bank.
What Is a Corporate Bond?
Similar to a mortgage with a bank, bonds are an issue by a borrower to a lender. When you buy a corporate bond, you are loaning your money to a corporation for a predetermined period of time (known as the maturity). In most cases, the bond's par value is $1,000. This is the face value of the bond and the amount the company (the borrower) will repay the lender (you) once the bond matures.
Of course, you're not going to loan your money for free. The borrower must also pay you a premium, known as a "coupon," at a predetermined interest rate in exchange for using your money. These interest payments are usually made every six months until the bond reaches maturity.
Types Of Bonds
There are three important factors to consider before buying a bond. The first is the issuer. The second is the interest (or coupon) you will receive. The third is the maturity date, the day when the company must repay your principal.
Objectives and Risks
Corporate bonds offer a slightly higher yield because they carry a higher default risk than government bonds. Corporate bonds are not the greatest for capital appreciation, but they do offer an excellent source of income, especially for retirees. Corporate bonds are also highly useful for tax-deferred retirement savings accounts, which allow you to avoid taxes on the semiannual interest payments.
The risks associated with corporate bonds depend entirely on the issuing company. Purchasing bonds from well-established and profitable companies is much less risky than purchasing bonds from firms in financial trouble. Bonds from extremely unstable companies are called junk bonds and are very risky because they have a high risk of default.
Many corporate bonds offer a higher rate of return than government bonds for only slightly more risk.
The risk of losing your principal is very low if you only buy bonds in well-established companies with a good track record. This may take a bit of research.
Fixed interest payments are taxed at the same rate as income.
Corporate bonds offer little protection against inflation because the interest payments are usually a fixed amount until maturity.
Three Main Uses
1. Capital Appreciation
3. Safe Investment
How to Buy Or Sell a Corporate Bond
Corporate bonds can be purchased through a full service or discount broker, a commercial bank or other financial intermediaries. The best time to buy a corporate bond is when interest rates are relatively high.
You can also open an account with a bond broker, but be warned that most bond brokers require a minimum initial deposit of $5,000. If you cannot afford this amount, we suggest looking at a mutual fund that specializes in bonds (or a bond fund).
If you do decide to purchase a bond through your broker, he or she may tell you that the trade is commission free. Don't be fooled. What typically happens is that the broker will mark up the price slightly; this markup is really the same as a commission. To make sure that you are not being taken advantage of, simply look up the latest quote for the bond and determine whether the markup is acceptable.
For further reading, see Bond Basics: How Do I Buy Bonds?, Bondholders' Rights and Debt Reckoning.