Corporate Bonds

Overview

If a business wants to raise funds without selling shares, one of the main ways is to borrow money directly from investors by issuing a bond. This works much like a government bond: the investor lends the company a set amount of money, receives a fixed coupon at regular intervals, and is repaid the original sum at maturity. 

The difference lies in the borrower. A government is able to raise taxes or, in the case of the UK and the US, print its own currency to meet its commitments; a company cannot do either of these things and might therefore end up running out of money. 

This additional risk is the reason why corporate bonds almost always offer a higher yield than government debt with the same maturity, and the magnitude of that difference is one of the most closely monitored indicators in the fixed income markets.

Credit ratings

Since thousands of companies publish bonds but most investors don't have the time to examine each one's financial position from scratch, the market depends on three main credit rating organisations, Moody's, S&P Global and Fitch, to carry out that task and sum it up in a simple letter rating. 

The ratings divide the market into two main groups. Bonds that are considered investment grade (approximately BBB and above) are generally issued by companies that are financially stronger, are usually larger and more established, and therefore have a lower level of perceived default risk. 

High-yield bonds, often referred to as junk bonds, are below this level and are issued by companies that are more leveraged, smaller, or financially weaker, paying investors a considerably higher coupon as compensation for the additional risk. 

The line between the two types of bond is of great importance in practice because many large pension funds and insurers are only allowed to hold investment-grade debt, so if a company is downgraded across that line, in other words, it becomes a so-called "fallen angel", there can be a forced sale which causes its bond price to drop regardless of what is happening with the company.

Credit spread

The figure that sums up all this is the credit spread, which is the additional return that a corporate bond offers over a government bond with the same maturity. 

For example, if a 10-year UK government bond yields 4.4% and a 10-year bond from a reputable, investment-grade company yields 5.3%, then the credit spread is 0.9 percentage points, or 90 basis points, this is the market's assessment of the cost of lending to that company rather than to the government. 

Credit spreads are not constant; they change continuously as investor attitudes shift, widening when they worry about default (usually during an economic slowdown or after a company-specific incident) and narrowing when confidence returns. 

One of the most reliable early indications of financial stress is how credit spreads move, either across the market as a whole or for a particular issuer, often shifting well before a rating agency issues a formal downgrade. 

The same fundamental principle, measuring the risk of default in terms of a spread, is also the basis on which credit default swaps are priced. 

How companies issue bonds

Corporate bonds are not sold to the general public in the same way that shares can be purchased on an exchange with just a few clicks. 

Rather, when a company wants to raise money by issuing debt it usually employs an investment bank to look after the operation: the bank determines the price of the bonds, assesses the level of interest from institutional investors such as pension funds and insurers, prepares a list of orders, and then distributes the bonds to the buyers, charging a fee for assuming the risk of placement, just as it does when underwriting a share issue. 

Companies well known across all sectors carry out this practice regularly: a tech firm with a large amount of cash, for example, might issue bonds to finance share buybacks rather than repatriate the money it has held overseas, an oil company might take out a loan to fund a long-term capital project, and a reputable high street retailer which is just below investment grade might have to offer a considerably higher coupon than a blue-chip pharmaceutical or utility company which has a stronger balance sheet.

Risks

Three risks are associated with corporate bonds and should be clearly distinguished. 

• The most apparent of these is default risk: just as with a government, a company may fail to pay the coupon or return the principal when it comes to maturity, and although bondholders have a higher priority than shareholders should the company go into liquidation, no assurance can be given as to the amount of money that will be recovered, high-yield investors in particular may end up losing a significant portion of their capital should the borrower go bankrupt. 
• Liquidity risk arises because corporate bonds are traded far less frequently than gilts or Treasuries; since many are purchased by institutions and held until maturity, the secondary market tends to be thin, the spread between the buying and selling prices is wider, and it becomes more expensive than it appears on paper to get rid of a position quickly. 
• Lastly, corporate bonds face the same interest rate risk as any other fixed-coupon bond: if market yields rise after a bond is issued, its price falls to compensate, and the longer the time to maturity, the greater the effect.