What it means
When a company needs long-term money it can sell shares, borrow from a bank or issue bonds. Bonds appeal to larger borrowers because the money comes from many investors at once, the terms are fixed for years, and the interest rate is often lower than a bank would charge for the same size of facility.
For the investor, the attraction is predictability. A bond pays a known amount on known dates, which suits pension funds and insurers matching future liabilities, though that predictability is only as good as the issuer's ability to pay.
Price and yield move in opposite directions once a bond is trading. If market interest rates rise after issue, an existing bond paying a lower coupon becomes less attractive and its price falls until the return it offers matches what is available elsewhere.
Credit quality drives almost everything else. Rating agencies grade issuers, and bonds from stronger companies pay lower coupons, while lower-rated issuers pay a wider spread over government debt to compensate for higher default risk.
Bond documents also carry covenants, which are promises the company makes about how it will behave, such as keeping debt below a stated multiple of earnings. Breaking a covenant can make the whole amount repayable immediately, so treasury teams monitor them as carefully as the interest payments themselves.
Bonds come in several shapes beyond the plain fixed-coupon version. Secured bonds are backed by specific assets, convertible bonds can be exchanged for shares on agreed terms, and floating rate notes pay a margin over a benchmark rate rather than a fixed coupon, each of which shifts risk between issuer and investor in a different way.
In practice
Real-world examples.
Example
A supermarket group issues $400,000,000 of ten-year bonds at a 5% coupon to refinance bank debt maturing next year. The treasurer locks in the rate before an expected round of central bank increases.
Example
An insurance company buys twenty-year bonds from a water utility because the timing of the coupons matches the annuity payments it has promised its policyholders. Credit quality matters more to the buyer than yield.
Example
A manufacturer's bonds fall from $1,000 to $870 after a profit warning, pushing the yield up sharply. A credit fund buys at the lower price, judging that the business can still cover its interest twice over.
Think of it
“Corporate bond is a company borrowing by issuing tradeable debt-corporate IOUs.
Formula
Calculation
Current yield = Annual coupon payment / Market price
Take a bond with a face value of $1,000 and a 6% coupon, which pays 6% x $1,000 = $60 of interest each year. If the bond trades at $960 rather than face value, the current yield is $60 / $960 = 6.25%, higher than the coupon because the buyer pays less than $1,000 for the same $60 income. From the issuer's side, raising $50,000,000 at that 6% coupon costs 6% x $50,000,000 = $3,000,000 in interest each year, and because interest is deductible, a 25% tax rate reduces the net cost to $3,000,000 x 0.75 = $2,250,000, an after-tax cost of $2,250,000 / $50,000,000 = 4.5%.Case study
Seen in the real world.
Kestrel Foods is an illustrative, fictional food processor created to show corporate bond mechanics. Facing a $50,000,000 bank facility maturing in eighteen months, its board compared rolling the bank loan at a floating rate against issuing a seven-year bond at a fixed 6% coupon.
The bond looked more expensive on day one, since the bank was quoting less at the time. What decided it was certainty: the bond fixed $3,000,000 of annual interest for seven years, or $2,250,000 after the tax deduction, while the bank facility would reprice every quarter and needed renegotiating twice inside the same period.
Two years into this fictional story market rates had risen by two percentage points. Kestrel's interest bill was unchanged, its bonds traded below face value in the secondary market, and the treasurer quietly bought back a small tranche at a discount, retiring debt for less than its face value.
Watch out
Common mistakes.
- Assuming bonds are risk-free because they pay a fixed coupon. Issuers can default, and even sound bonds lose market value when interest rates rise.
- Confusing the coupon with the yield. The coupon is fixed at issue, while the yield depends on the price an investor actually pays.
- Ignoring covenants when comparing two bond offers. A cheaper coupon with tight covenants can be far more restrictive than a slightly dearer bond with room to manoeuvre.
Questions
People also ask.
How do corporate bonds differ from shares?
Bondholders are lenders with a contractual right to interest and repayment, while shareholders are owners with no guaranteed return but a claim on all remaining profits.
What happens if the company goes bust?
Bondholders rank ahead of shareholders in the queue and often recover part of their money, though unsecured bondholders sit behind secured lenders.
Why would a company issue bonds instead of taking a bank loan?
Bonds usually offer longer maturities, larger amounts and fewer ongoing conditions, at the cost of a public issuance process and continuing disclosure.
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