How do corporate bonds work? A lot of people have heard about different types of bonds. These bonds are either government bonds or corporate bonds. In this article we will look at what corporate bonds are and how they work.
What are corporate bonds?
A corporate bond is a debt-based investment where a corporation issues out a bond and sells it to investors. This basically means that investors lend money to the company with the hopes of getting it back plus interest.
This is different from buying stock, when buying stock, you are buying ownership of the company. You get paid from dividends when you are a shareholder and own a piece of the company. With a corporate bond you are lending money to the company.
Why do companies issue corporate bonds?
Companies issue out bonds because they want to fundraise for their projects or day to day operations. Companies raise finance either through equity financing or debt financing, equity financing requires them to give up a percentage of ownership of the company.
Corporate bonds allow companies to raise all the money they need to fund their projects.
How safe are corporate bonds?
Corporate bonds are safe but not as safe as government bonds, they are also safer than purchasing stocks. A company still has to pay its creditors even when it is bankrupt.
Corporate bonds are usually underwritten by a credible bank, this is some form of insurance. It ensures that investors will get their money no matter what happens. There are companies that have an excellent track record of issuing bonds, they are a safer bet than a company with no track record or a bad one.
Corporate bonds are reviewed for their creditworthiness of the issuer by rating agencies. The highest rated bonds are commonly referred to as “Triple A” rated bonds. The lowest rated bonds are called high yield bonds, this is because they have a greater interest rate. Lowest rated bonds are also known as “junk” bonds.
How are they different from government bonds?
The difference between corporate bonds and government bonds is the issuer. Corporate bonds are issued by private or public companies while government bonds are issued by the government.
Government bonds are way safer than corporate bonds because they carry a very low risk. The government is not likely to ever default on its debt, especially when the bonds are issued the in the currency of the country, like South African Rands.
Corporate bonds give greater interest, government bonds are not that exiting for other investors. The average interest rate on inflation adjusted government bonds in South Africa is around 3%. While the average corporate bond is between 6 and 8 percent.
Selling your bond
A lot of people buy corporate bonds and hold them until maturity, that is until the term expires. Corporate bonds pay out your interest semi-annually. If you invest R10 000 in a bond that has an interest rate of 5% then you will receive R500 every 6 months, twice per year. Which will be a total of R1 000 per year.
Let’s say you invested in this bond for a period of 5 years, you might be pressed for cash on your second year. This might force you to sell the bond, you might not be able to sell the bond for R10 000, the investor buying your bond will look at the number of interest payments you have received and value your bond based on how many interest payments are still left.
The bond reaches its maturity at the end of the lifetime of the bond. Upon maturity you will get your initial investment back. You will get this after having received your interest during the lifetime of your bond.
This was an overview of how corporate bonds work; this information is directed to South Africans. Do you have any thoughts or questions? Comment below.