What are corporate bonds?

 

  1. The investor buys a bond issued by a corporation;
  2. The corporation provides collateral in several forms depending on the type of bond;
  3. The investor gets paid interest and principal at maturity backed by the collateral.

Corporate bonds are bonds issued by companies. They have a maturity date from one to thirty years. Different forms of collateral are used to backup the payments.  In general, corporate bonds have higher yield than treasury bonds but also carry more risk. This means that the default rate for corporate bonds is more important:

  • When a bond hits default rate that means the issuer (the company) has gone bankrupt or has any other reason that it can’t pay the interest and par value anymore. 

Companies have a higher chance of hitting a default rate. The default rate is different for each market segment. The average default rate is actually pretty low (1%). The highest default rate can be found in the energy market at 3.7% at this time of writing (december 2021). In July 2020 during the covid pandemic this was much higher at 15%+.

To calculate the losses investors can use the recovery rate. The recovery rate calculates the loss if a bond defaults. The recovery rate is a percentage of the par value. There are many factors that determine the recovery rate. The credit rating and the type of bond are most important to calculate the recovery rate. This principle is also used for other loans like mortgages and personal loans. The recovery rate for bonds can be calculated by:

  • Amount recovered till default / par value

Corporate bonds can be split into five main categories:

  • Public utilities
  • Industrials
  • Banks and finance companies
  • Transportations
  • International Issues

Companies are further divided between these categories based on their field of work. There are a few different types of corporate bonds:

  • High yield or junk bonds
  • Guaranteed bonds
  • Mortgage bonds
  • Collateral trust bonds
  • Equipment trust certificates
  • Debenture bonds
  • Convertible bonds

High yield or junk bonds

High yield or junk bonds are bonds that have a low credit rating. They are very risky but can have a higher yield. Most of the time these bonds are made available by companies that do not have a big income flow yet but rely more on future predictions. These bonds can also be issued by companies that are already in large debt. They are risky because high yield bonds do not have any collateral. You have zero guarantees on getting your money back if the company defaults. 

BB-rated bonds seem to default at about 2% per year on average. B-rated bonds default about 4% per year.

Guaranteed bonds

As the name suggests, these bonds are guaranteed. In this case a third party is providing collateral if the issuing party has trouble fulfilling the payments. That does not mean these bonds are 100% guaranteed as the third party can also go bankrupt. But overall the protection against default is pretty high.

Mortgage bonds

A mortgage bond is a bond that has real estate as collateral. Just like when you take a mortgage at the bank where your house acts as collateral for the bank. If something goes wrong and you can’t pay your mortgage anymore, the bank can sell your house. If the issuer of the mortgage bond can’t pay the bills anymore, you can claim to sell (a part) of the real estate. 

Collateral trust bonds

Collateral trust bonds use other kinds of securities to act as collateral for the bond. For example, a company that holds stocks or bonds from other companies. These companies have no real estate and other things to act as collateral.

Equipment trust certificates

An ETC can be seen as a hybrid version of a lease and bond contract. ETC’s are used for assets that can be sold right away. The borrower is paying the debt and the asset is held in trust. The trust can issue ETC’s which investors can buy. By doing so, investors provide the trust capital to buy the asset. Once all debt is paid, the ownership is transferred to the borrower.

ETCs are nowadays mostly used by airplane companies. Because ownership of the airplanes only changes to the airline when the ETC reaches maturity. Meaning the airline company does not own any planes in case of bankruptcy. And because they are not the owner they don’t have to pay taxes.

Debenture bonds

Debenture bonds are the same as unsecured bonds I talked about before. Many companies issue unsecured bonds. Simply meaning there is no collateral to back up the bond. This is more risky but can have higher rewards. 

Convertible bonds

Convertible bonds are mostly unsecured bonds. They provide the option to convert into shares of the company's stock after a specific period of time. If the company can’t pay anymore but the bond was already converted to a stock, then it depends if the company goes bankrupt to get any money back.

An overview:

Type Years until Maturity Interest rate Collateral
Junk bonds Variable Fixed Nothing
Guaranteed bonds Variable Fixed A third party
Mortgage bonds Mostly 5,15,20 or 30 years Fixed Real estate
Collateral trust bonds Variable Fixed Stocks, bond, notes or other securities
Equipment trust certificates Variable Fixed Underlying asset (car or airplane)
Debenture bonds Variable Fixed Nothing
Convertible bonds Variable Fixed Nothing (mostly unsecured bonds)

As with all bonds, principal is paid when the maturity date is reached. For corporate bonds the years until maturity can differ. The biggest difference is the used collateral. For treasury bonds the collateral is the U.S. Government. Corporate bonds are relying more on corporations, third party’s, other underlying assets or nothing at all.

Corporate bonds and taxes

Corporate bonds are taxable at the local, state and federal level. Meaning you always have to pay taxes. Corporate bonds are the highest yielding bonds and have the highest default risk.

Pro and cons of corporate bonds

Pro’s Cons
Highest yielding bonds Mostly unsecured
Many different options Highest risk of defaulting
High liquidity for some types Interest rate risk
  Selling over the counter
  Can be hard to sell in the secondary market

Sometimes corporate bonds are hard to sell on the secondary market. That is because corporate bonds are mostly sold over the counter. Normally, bonds are sold through an exchange or broker. While over the counter selling does not require any intermediate party. Also, trades that are made are not publicly visible when you are over the counter trading. OTC trading is less transparent and therefore might have less liquidity resulting in higher prices. If liquidity is low that means there are not many buyers and sellers resulting in huge spreads. This can make it difficult to sell your bonds.



Chapters: The Ultimate Investing Guide

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