What is it?
Companies raise capital through corporate bonds. It is essentially a security that an investor buys to get a periodic interest payment from the company for a fixed period. Bonds may be issued by a company as a private placement or a public issue. While a private placement is accessible only to a select few, a public issue is made to the public. Just as in case of an equity initial public offering, for a new bond issue the company needs to have a prospectus. And after the issue, bonds are listed on a recognized stock exchange and are traded.
Terms you should know
Coupon: A coupon refers to the rate of interest payable to the investor for a fixed period. A coupon is set as a percentage of the face value of the bond. The face value is the price at which the bond is issued. The coupon may be a fixed or a floating rate. The floating rate is linked to a relevant benchmark, such as Mibor, and the payout is made at a rate below or above the benchmark rate as mentioned in the offer document.
Maturity: This is the date when the bond matures. The issuer or the company has to repay the face value of the bond along with the accrued interest to the investor. After this transaction is over, the bond ceases to exist.
Put and call options: Some bonds come with an explicit option where either the issuer of the bond can buy it back before maturity or the buyer of the bond can sell it back to the issuer before maturity. The first type refers to a call option and the second refers to a put option. The bonds with call option usually offer the investor a higher rate of interest, as they accept the risk of buy-back before maturity. Alternatively, bonds with put options usually come with a lower interest rate as the investor has the right to sell before maturity.
Bonds are perceived to be less risky compared with shares. However, they come with their own set of risks.
Credit risk: The issuer company may default on interest payments or may not be able to pay back the principal amount. So one must analyse the ability of the company to pay back its dues. One way is to look at the cash flows that the company generates. Most often issuers get their bonds rated by credit rating agencies, who essentially do the above analysis and rate a company based on its financial health. This rating gives the investor an indication of the company’s ability to uphold its obligations.
Interest rate risk: The price of bonds is inversely linked to interest rates. Which means that for listed bonds, price falls if interest rates head higher and vice-versa. In case you have invested in a bond via an exchange, you will see fluctuations in bond price.
Liquidity risk: Corporate bonds listed on the exchange often don’t have sufficient trading volumes. This means that if you want to sell your bond before its maturity date, you may not find a buyer. So exiting the security when you want and at a price that you expect may be a problem.