As discussed earlier in - What is an IPO? - when a company is in need of money it either raises funds via IPO or could raise debt by issuing Corporate Bonds or through Loans.
After a discussion on IPO, today we will learn about corporate bonds and loans.
The primary difference between Bonds and Loan is that bonds are the debt instruments issued by the company for raising the funds which are tradable in the market i.e., a person holding the bond can sell it in the market without waiting for its maturity, whereas, loan is an agreement between the two parties, mostly with a bank, where one person borrows the money from another person which are generally not tradable in the market.
Now that we know loans have nothing to do with retailers, we shall focus more on CORPORATE BONDS!
What are Corporate Bonds?
Earlier when a company needed money, they used to approach banks for which the bank used to charge 10-12% interest. Whereas when we make an investment in Fixed Deposit banks give us interest of 5-6%
However, with corporate bonds the company can raise money directly from retailers (investors like you and me) @ 7-10% interest.
Therefore, bonds are a capital-raising tool by which corporate business entities can gather investment from the financial market. It is generally compared with Fixed Deposits. It is also referred to as Non-Convertible Debentures i.e these cannot be converted into a particular number of company shares at a particular time. However, please note that with the higher interest from bonds, comes higher risk - they are usually illiquid, you cannot sell them till maturity, they can default on your amount & interest. Lets learn more about them :
Terms you should know:
- Face Value: Face value, also known as the par value. It refers to the bond's price when it was first issued.
- Coupon Rate: Coupon rate is nothing but rate of interest.
- Coupon Payment Date: Coupon payment refers to when interest is paid on a bond between its issue date and the date of maturity, for example, annually or semi- annually.
- YTM: It is the total expected rate of return that you will earn if the bond is held to maturity.
- Date of redemption: It is nothing but the scheduled maturity date. It is the date on which the bonds become payable.
- Redemption Value: It is the price at which an investor may choose to repurchase a security before its maturity date. For example if you did not purchase the bond at its face value you can later buy it on redemption value. There are three types of redemption value.
- Redemption at par: This is when Redemption Value is same as Face Value
- Redemption at discount: When the redemption value is less than the face value it is known as redemption at discount.
- Redemption at premium: This is when the redemption value is more than the face value of the bond.
What if the company goes bankrupt?
If a company defaults on its bonds and goes bankrupt, you no longer receive principal and interest. Once the process is completed, you might receive newly issued bonds or cash whose value may not equal the value of the bonds they own.
Therefore, it is important to invest in a bond after checking bond ratings and understanding the credibility of the underlying company. A bond rating is a letter-based credit scoring scheme used to judge the quality and creditworthiness of a bond. It is also important to know /study the companies in whose bonds you are investing as its rating could drop and you may lose your investment or the same may get stuck if the management changed while you hold a AAA rated bond.
Things to keep in mind while investing in Corporate Bonds:
- High returns: Bonds are currently offering an annual interest rate (coupon rate) in the range of 8-11% and the yield (total return on bonds if unsold before maturity) on them is at least 9%, which is equal to or higher than the rates offered by bank deposits.
- Creditworthiness: It is safe to invest in bonds with. better credit quality (the company’s ability to pay) i.e -AAA, AA & A, lowering the chances of default. The lower end indicates poor quality and higher chances of default.
- Risks of Bonds: Look beyond ratings. Ratings do not account for all the risks associated with bonds. New risks could arise after you have purchased the bond. Avoid investing in the bonds of companies where revenue shows a declining trend and the debt burden is increasing.
- Exit options: Consider your liquidity requirement before investing in corporate bonds and match your investment horizon with the bond’s maturity period, which is generally 5-10 years.
Please note that bond markets are not yet developed in India. It is a good investment option for those who have surplus and are willing to take risk. For regular investors, investing in corporate bond mutual funds is a safer option as your risk is diversified. We would not advise a starter investor to invest in corporate bonds by only looking at the higher returns you generate from the same.