Corporate bonds: benefits and associated risks

Many investors don't like the volatility associated with equities. They seek safer investment instrument than equity but want better return than Government bonds. Corporate bonds may be a ideal investment instrument for such investors. Read on to know about corporate bond, its advantages and risks associated with it.

Every sensible investor wants greater return with minimal risk. Most of the investors don't like volatility. Because of this reason, many investors don't want to invest in equity or equity funds. They search for safer option than equities but seek better return than that of the Government bonds. For such investors, corporate bond is an attractive option.

What is corporate bond

Corporate bond is a debt instrument issued by a corporate house/ company to raise money from investors to finance its business activities. According to Wikipedia: "A corporate bond is a bond issued by a corporation in order to raise financing for a variety of reasons such as to ongoing operations, M&A, or to expand business." The holder of such bond receives interest from the corporate house/company periodically for a fixed period of time and gets back the principle and the accrued interest at the end of the maturity period. In India, corporate bonds and debentures are used to mean same/similar type of debt instrument; however, in some countries like the U.S, there are some differences between the corporate bonds and the debentures.

Who can issue

In India, both public and private companies can issue corporate bonds. In addition, a company incorporated in India and which is a part of a multi-national corporate, can also issue corporate bond.

Differences between corporate bonds and equity shares

In case of equity share, the investor in equity shares of a company is a part-owner of the company. He/She also enjoys voting rights in the AGM of the company. The investor in equity share also gets dividend paid by the company. However, the investor in corporate bond is a lender to the company and he/she has no ownership right. Naturally the investor in corporate bond does not enjoy voting rights. Furthermore, an investor in the corporate bonds earns interest paid by the company, instead of the dividend. Generally, corporate bonds are less risky than equity shares.

Differences between corporate bonds and bank Fixed Deposit (FD)

In case of bank fixed deposit, a fixed amount of interest is being paid periodically by the bank. Moreover, the deposit in a bank (in the case of FD) is guaranteed up to a maximum of Rs. 1,00,000/- for both the principal and the interest. In case of corporate bonds, the interest may be fixed or varied, depending upon the fact whether the interest rate announced is fixed or floating. Moreover, the investment is not guaranteed by the Government or RBI.

How to invest

A company planning to raise funds through corporate bond will float a public issue. Generally, retail investors invest in corporate bonds through the public issues. This is called primary market. In case of the listed bonds, an investor can also buy such bonds through the exchange. This is called the secondary market.

Fixed rate bonds and floating rate bonds

The fixed rate bonds will pay the interest at a fixed rate periodically as per the interest rate specified when the bonds were issued. The floating rate bonds have the interest rates pegged to a benchmark. If the benchmark rate changes, the interest rate of the bonds will also change. The floating rate bond is riskier than the fixed rate bond. However, it may be noted that the interest payment are sometime cumulative and sometime non-cumulative.

What is the maturity date

Maturity date of a corporate bond is the date on which the bond matures. This means that on the maturity date the issuing company repays fixed value of the bond along with the interest accrued to the investor. There may be short-term, middle-term or long-term bonds depending upon the maturity period.

Benefits of investing in corporate bonds

If an investor wants periodical fixed income, corporate bonds are the most ideal investment instrument. Corporate bonds offer a much higher rate of interests compared to FDs or various postal savings schemes. Furthermore, corporate bonds are not as risky as the equity instruments. The volatility of corporate bonds is much less than that of equity instruments. If the bond is listed, it can be sold in secondary market before the maturity. If a listed bond can be sold at higher price, it provides capital appreciation.

Risk associated with corporate bonds

An investor must remember that corporate bond is not devoid of risk. A corporate bond is associated with four types of risks, viz., credit risk, pre-payment risk, interest rate risk and liquidity risk.

Credit risk: if the issuer of corporate bond goes out of business, the investor may not receive interest payment or get back the principal amount.

Pre-payment risk: If the corporate bond contains provision which allows the issuing company to redeem the bond before the due date, the investor is exposed to pre-payment risk.

Interest rate risk: When an investor invests in a listed corporate bond, he/she faces the risk of volatile interest rate regime, which causes change in the market price of the bond. If the interest rate goes up, the price of the bond goes down, and vice-versa.

Liquidity risk: Although the listed corporate bonds can be theoretically sold in the secondary market, in actuality, very few buyers are available. The corporate bonds are not as liquid as equity scripts.

Concluding comments

Although corporate bond is a very attractive option for such investors who do not like volatility, it is advised that before investing in corporate bonds, the financial condition of the company issuing such bonds, credit rating, prevailing interest rate and other conditions must be carefully checked.

Article by Partha K.
“Those who will not reason, are bigots, those who cannot, are fools, and those who dare not, are slaves.” - George Gordon Byron

Follow Partha K. or read 262 articles authored by Partha K.

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